Capital Allocation and Bank Management Based on the Quantification of Credit Risk

by Kenji Nishiguchi of Sakura Bank, Limited,
Hiroshi Kawai of Sakura Bank, Limited, and
Takanori Sazaki of Sakura Bank, Limited

October 1998

Introduction: Liberalization and deregulation have recently accelerated. It is therefore useful to keep risk within a certain level in relation to capital, considering that financial institutions must control their risk appropriately to maintain the safety and soundness of their operation.  In 1988, the Basle Capital Accord--International Convergence of Capital Measurement and Capital Standards--introduced a uniform framework for the implementation of risk-based capital rules.  However, this framework applies the same "risk weight" (a ratio applied to assets for calculation of aggregated risk assets) to loans to all the private corporations, regardless of their creditworthiness.  Such an approach might encourage banks to eliminate loans that can be terminated easily while maintaining loans with higher risk.

As shareholder-owned companies, banks are expected to maximize return on equity during this competitive era, while performing sound and safe banking functions as financial institutions with public missions.  Banks are finding it useful to conduct business according to the management method that requires them to maintain risk within capital and to use risk-adjusted return on allocated capital as an index of profitability based on more accurate quantification of credit risk.

Published in: FRBNY Economic Policy Review, Vol. 4, No. 3, (October 1998), pp. 83-94.

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