The Basel Committee on Banking Supervision released a couple of papers today, one dealing with credit risk assessments for loans, the other providing supervisory guidance on the use of the fair value option for financial instruments by banks.

The Basel committee issued a paper addressing how common data and processes related to loans may be used for assessing credit risk, accounting for loan impairment and determining regulatory capital requirements. The guidance supersedes previous guidance from July 1999.

This paper discusses necessary processes for banks in sound credit risk assessment, valuation and control and the responsibilities of boards of directors and senior management to maintain appropriate provisions for loan losses. The paper also provides guidelines for how supervisors should evaluate the effectiveness of a bank’s credit risk policies and practices when assessing the appropriateness of their credit risk assessment process, loan loss provisions and regulatory capital.

“Sound credit risk assessment and valuation processes are essential if banks are to recognise deterioration in credit quality in an adequate and timely manner. Such thorough processes will promote more meaningful capital requirements and financial market stability,” said Jaime Caruana, chairman of the Basel Committee and Governor of the Bank of Spain.

Professor Arnold Schilder, member of the Basel Committee, chairman of its Accounting Task Force and executive director at the Netherlands Bank, added “This paper is relevant to all banks and is more principles-based than the loan accounting guidance, which it supersedes. The practices it describes are relevant regardless of the accounting framework applied or the approach used in calculating credit risk regulatory capital requirements.”

The committee also released guidance on the use of the fair value option. The supervisory guidance is structured around seven principles that fall into two broad categories: supervisory expectations relevant to the use of the fair value option, and supervisory evaluation of risk management, controls and capital adequacy. The paper addresses such matters as bank risk management and capital assessment issues.

“Banking organisations are mainly employing the fair value option to better reflect sound economic hedging strategies in today’s mixed-attribute accounting framework. Banking supervisors have recognised the need to communicate fundamental supervisory expectations in this important and sensitive area,” Caruana said. “I believe this paper will provide supervisors with essential tools for this purpose.”