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IRB Asset and Default Correlation: Rationale for the Macroprudential Add-ons to the Risk-Weights

Henry Penikas

No wps56, Bank of Russia Working Paper Series from Bank of Russia

Abstract: Basel III allows for the use of statistical models. It is called the internal-ratings-based (IRB) approach and is based on the (Vasicek, 2002) model. It assumes assets returns are standard normally distributed. It suggests incorporating different asset correlation (R) functions to assess credit risk for the loan portfolio, or the risk-weighted assets (RWA). The asset correlation func-tion solely depends on the individual default probability (PD) given certain credit exposure type. At the same time, the IRB approach requires developing PD models to predict the dis-crete default event occurrence. This means that the IRB approach is based on the Bernoulli trials. We investigate the impact of the asset returns’ correlation for the Bernoulli trials. We show that when Bernoulli trials are considered, the credit risk estimation significantly deviate from the val-ues derived under the normality assumption of asset returns. We investigate the simulated and real-world credit rating agencies’ data to specifically demonstrate the scale of the credit risk underestimation by the IRB approach. Therefore, macroprudential add-ons are of use to offset such IRB limitations.

Keywords: Basel II; IRB; correlated defaults; asset correlation; binomial distribution; Bernoulli trials; macroprudential add-ons (mark-ups) (search for similar items in EconPapers)
JEL-codes: C25 G21 G28 G32 G33 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2020-07
New Economics Papers: this item is included in nep-acc, nep-ban and nep-rmg
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