Regulatory capital determination and Its implications for internal ratings-based credit risk model development and validation

Cao, Honggao (2012): Regulatory capital determination and Its implications for internal ratings-based credit risk model development and validation.

Abstract

Focusing on the interconnections between the Basel regulatory capital formula and several well-specified statistical models, this working paper seeks to understand some of the important issues embedded in the Basel Accord. These include: Where does this formula come from? What risks does it try to capture? Why does the Basel Accord stipulate that the formula be implemented on a basis of homogeneous segments for retail exposures or similar risk ratings of wholesale obligors? Is there any desirable property on the number of loans for a segment (or obligor group)? Why is LGD treated as a constant as opposed to a random variable? When covering expected loss – and determined independently – how is the loss reserve related to the minimum regulatory capital? Answers to these questions have some important implications for Basel model development and validation.

• Item Type: MPRA Paper
• Language: English
• Keywords: Basel, Basel Model Development, Basel Model Validation, Regulatory Capital, Credit Risk Model, Basel Capital Formula
• Subjects: G - Financial Economics > G1 - General Financial Markets; G - Financial Economics > G1 - General Financial Markets > G18 - Government Policy and Regulation; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; G - Financial Economics > G3 - Corporate Finance and Governance > G38 - Government Policy and Regulation

References

Basel Committee on Banking Supervision. (2004). “Background Note on LGD Quantification,” Working Paper, Bank for International Settlements.

Basel Committee on Banking Supervision. (2005). “An Explanatory Note on the Basel II IRB Risk Weight Functions,” Working Paper, Bank for International Settlements.

Céspedes, J. (2002). “Credit Risk Modeling and Basel II,” ALGO Research Quarterly, 5(1): 57-66.

Gordy, M. (2003). “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules,” Journal of Financial Intermediation, 12(3): 199-232.

Kiefer, N., and C. Larson (2003). “Biases in Default Estimation and Capital Allocations under Basel II,” Unpublished Monograph, retrieved on November 13, 2012 from http://www.arts.cornell.edu/econ/kiefer/biases_pd_cap_nmkcel_14JUN03.pdf

Kochendörfer, A. (2011) “Vasicek Single Factor Model,” Retrieved on August 3, 2012 from http://www.mathematik.uni-kl.de/~seifried/eng/teaching/teach_10ws/presentations/12_kochendoerfer.pdf

Merton, R. (1974). “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates,” Journal of Finance, 29: 449-70.

Schönbucher, P. (2002). “Taken to the Limit: Simple and Not-so-simple Loan Loss Distributions,” Working Paper, Department of Statistics, Bonn University. Retrieved one August 3, 2012 from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=378640

Thomas, H., & Z. Wang. (2005). “Interpreting the Internal Ratings-Based Capital Requirements in Basel II,” Journal of Banking Regulation, 6, 274–289

US Rules and Regulations. (2007). “Risk-Based Capital Standards: Advanced Capital Adequacy Framework – Basel II,” Federal Register, 72 (235).

Vasicek, O. (1987). “Probability of Loss on Loan Portfolio,” KMV manuscript.

Vasicek, O. (1991). “Limiting Loan Loss Probability Distribution,” KMV manuscript.

Vasicek, O. (2002). “Thee Distribution of Loan Portfolio Value,” Risk, 15 (12): 160-162.