A risk-factor model foundation for ratings-based bank capital rules

Michael Gordy

No 2002-55, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: When economic capital is calculated using a portfolio model of credit value-at-risk, the marginal capital requirement for an instrument depends, in general, on the properties of the portfolio in which it is held. By contrast, ratings-based capital rules, including both the current Basel Accord and its proposed revision, assign a capital charge to an instrument based only on its own characteristics. I demonstrate that ratings-based capital rules can be reconciled with the general class of credit VaR models. Contributions to VaR are portfolio-invariant only if (a) there is only a single systematic risk factor driving correlations across obligors, and (b) no exposure in a portfolio accounts for more than an arbitrarily small share of total exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

Keywords: Risk; Econometric models; Capital (search for similar items in EconPapers)
Date: 2002
New Economics Papers: this item is included in nep-fin and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (52)

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Journal Article: A risk-factor model foundation for ratings-based bank capital rules (2003)
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