Basel regulatory capital formula revised

Yimin Yang () and Min Wu
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Yimin Yang: Loyal Trust Bank, USA
Min Wu: #x2020;Tsinghua Alumni Association of Greater New York, USA

International Journal of Financial Engineering (IJFE), 2021, vol. 08, issue 03, 1-19

Abstract: Credit capital requirement is a key component of Basel implementation to assess a bank’s capital adequacy. Under the Internal Rating-Based approach, some risk parameters, including Asset Correlation, are implicit assumptions that cannot be observed directly. While some heuristic formulae of Asset Correlation for different business segments are provided by Basel, they may not be fully consistent with each bank’s loss experience and thus may cause systematic underestimation of banks’ capital requirement. To address this issue, we derive an equivalent capital formula in such way that the unobservable Asset Correlation is replaced by an observable and well-understood parameter called Default Volatility, which can be calibrated based on banks’ historical loss experience. This new approach simplifies parameter estimation process without requiring additional data, as well as making risk analysis such as stress testing more credible.

Keywords: Credit risk; Basel accords; capital requirement; Asset Correlation; probability of default; Default Volatility (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1142/S2424786321420068

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