Banks urged to improve risk models

The European Central Bank yesterday urged banks to improve the way they assess credit and internal risks.

The ECB said European Union banks had "broadly satisfactory" performance in lending but said there were concerns about less stringent requirements on how much collateral banks have to set aside to cover outstanding loans.

"Supervisory authorities consider it important to encourage banks to continue enhancing their methodologies for allocating economic capital according to their particular risk profile and to continue developing their internal risk management systems," the ECB said in the summary of a report on EU banks' credit margins and lending practices. The ECB's comments come as global regulators prepare to release a comprehensive draft rewrite of the 1988 Basel Accord dictating how banks assess risks and protect themselves against losses. The Basel II draft will be unveiled on January 16th.

Basel II for the first time addresses "internal risk" or operating risk - threats from a power outage, settlements failure or a rogue trader - and requires banks to set aside a certain amount of capital to cover those potential dangers.

The accord is expected to lower the amount of capital banks must set aside for credit risk, rewarding prudent lending and punishing risky behaviour.

Under Basel II, some larger banks will be allowed to introduce their own internal credit ratings systems to evaluate risks instead of relying on external ratings agencies like Moody's or Standard & Poor's.