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Basel II

Hugh Thomas

The Chinese University of Hong Kong

Shatin, NT, Hong Kong SAR, China

And

Zhiqiang Wang

Dongbei University of Finance and Economics

Dalian, Liaoning, China

We gratefully acknowledge the support of an Earmark Grant from the Hong Kong Research Grants

Council that made this research possible. Please address all correspondence regarding to this

paper to Hugh Thomas. Hugh-Thomas@cuhk.edu.hk.

Abstract

This paper describes the theoretical and institutional background to the formula

specified by the Bank for International Settlements Basel Committee on

Bankings internal-ratings based (IRB) approach to Pillar 1 of Basel II: minimum

capital requirements. The IRB formula is based on the Vasicek formula and is the

conditional probability of default of a single borrower with normally distributed

asset returns. We discuss the assumptions of the Vasicek formula and the

adjustments made to it in the IRB formula. From these discussions, we make 10

observations highlighting that the IRB formula does not correspond to industry

best practice, but represents a negotiated compromise to achieve simplicity,

portfolio invariance and bank acceptance of prescribed capital levels. The riskmeasurement implications of this compromise should be understood by regulators

and bankers in order to implement properly regulatory oversight, which

constitutes Pillar 2 of Basel II and by investors who will be should understand

disclosure requirements of Pillar 3.

Key words:

Basel II

Internal Ratings-Based Approach

Vasicek Formula

Bank Risk Capital

Bank Regulatory Capital

This article analyzes the internal ratings-based (IRB) approach of Basel II for

setting bank minimum capital requirements [1]. Bank managers frequently quantify

risk positions as dollars of equity capital put a risk (value at risk or risk capital) to

measure their banks internal performance and to set strategy [2]. A key goal of

Basel II is to make regulatory capital and risk capital definitions coincide more

1

closely than under Basel I [3] . The Basel Committee worked from the late 1990s to

2004 on Basel II setting out first a general direction and then two detailed drafts

[4,5,6] responding to industry comments. The completed Basel II rests on three

pillars: minimum capital requirements, the supervisory review process and market

discipline, but among the three, the first is by far the most complex, taking up about

three quarters of the pages of Basel II. At the core of Pillar 1 is the IRB approach.

We refer to the 1988 Capital Accord, the amendment to incorporate market risks by the Basel

Committee in 1996 and Basel Committee publications 9, 12, 18 and 36 collectively as Basel I [3].

The Basel Committee has explained the philosophy of the IRB approach

[1,7,8]. Economists at central banks have compared commercially available credit

risk models from a statistical point of view and have used them to calibrate the IRB

approach [9,10,11]. Wide briefly explains the IRB approach from a risk management

approach [12]. Yet bankers have expressed strong reservations about the opacity of

the equations and their coefficient values in the IRB approach [13]. To address these

reservations, we discuss the motives for the IRB approach, the basis of the IRB

formula, the derivation of the Vasicek formula that lies within IRB formula,

adjustments in the IRB formula and issues of concern to those who will apply it the

single factor model, correlation, granularity, loss given default and maturity.

Basel II in general and the IRB approach in particular are being implemented

to promote improved risk management in banking [1]. Among the top international

banks in the world, integrated quantitative risk measurement and management

systems are well developed. The advanced IRB approach2 is targeted only at top

international banks. The risk management capabilities of this select group of banks

who have devoted considerable resources to analysis of risk capital exceed those of

many bank regulators; hence, it is not surprising that Basel Committee notes that in

drafting Basel II it has gained substantially from industry interaction3. In fact a major

task of Basel II is to get regulators and bankers to speak the same language when

analyzing credit risk and its effect on required risk capital.

We focus discussion on the Advanced IRB approach. A major distinction between the Advanced and

the Foundations IRB approaches is that in the Advanced, banks supply internal estimates of both

probability of default and loss given default while in Foundations, regulators supply loss given default.

3

See [1] clause 15. The Committee sets as an objective that further movements towards accepting

internal bank models for setting bank capital adequacy standards are possible in future. See [1] clause

18

Prior to Basel II, regulators have not needed to understand modern risk

management. But under Pillar 2, regulators review the processes by which bankers

assess their own capital adequacy. This involves much more than confirming that

bankers have placed risk positions in appropriate buckets for the purpose of

calculating capital adequacy formulae. Banks implementing the IRB approach have

existing risk capital assessment criteria which differ considerably from the regulatory

capital calculations in the IRB approach. Without understanding the theoretical and

practical justification of the IRB formula, neither bank supervisors nor bankers can

assess the relative validity of regulatory and internal capital adequacy approaches.

Understanding the IRB approach is also important to investors. Under Pillar

3, banks will disclose new information about risk measurement and regulatory capital

requirements, with the greatest volume of such disclosures centering on the IRB

approach. The Basel Committee anticipates that the additional disclosure will

facilitate the markets assessment of bank capital adequacy. But such intelligent

assessment is possible only if investors understand that which is being disclosed.

2. Overview of the IRB Formula

The IRB formula is designed for the loan portfolios of large international

banks. To apply the IRB formula, each bank divides its assets into up to14 different

classes4. For thirteen of those of those classes all but equity stock the IRB

4

The 14 classes are composed of five major asset classes: corporate, sovereign, bank, retail and equity.

The major class corporate, in addition to standard lending to corporations, includes five classes of

specialized lending i.e., lending to special purpose entities including project finance, object

finance, commodities finance, income producing real estate and high volatility commercial real estate.

The major class retail is composed of three subclasses: secured by residential property, qualifying

formula applies. Each bank, based on its own internal ratings system, subdivides each

major asset class by borrower credit grades of relatively homogenous characteristics.

Banks may not select credit grades simply to minimize regulatory capital. They must

demonstrate to regulators that the credit grades provide appropriate predictive powers

and that the bank implements its credit grades for such internal functions as loan

pricing and monitoring in addition to simply meeting regulatory requirements.5 For

each credit grade, the bank provides key variables to plug into the IRB formula. We

simplify the IRB formula as follows:

K IRB LGD K V PD MATA

[1]

KIRB

LGD

KV

PD

The formula above calculates KIRB, being the amount of required capital expressed as a

percentage of exposure. Basel II finally specifies capital required as an amount of

currency. KIRB from equation [1] is multiplied by exposure at default (EAD),

expressed in currency (e.g., dollars, euros, yen, etc) to obtain the required capital

expressed in currency. EAD is gross exposure, is at least as large as current

exposure, and will be greater than current exposure in the case of committed but

undrawn lines of credit, where drawdown is likely to precede default.

revolving and all other retail. In addition, the major classes retail and corporate may contain

eligible purchased receivables.

5

See [1] clause 444. Basel II requires a minimum of seven borrower grades for non-defaulting

corporate, sovereign and bank borrowers and an unspecified number for retail borrowers in order to

provide a meaningful distribution. See [1] clauses 404 and 409.

probability of default (PD), and correlation between returns of the assets of the

obligor firms, , determine the value of KIRB. LGD is the maximum percent of a loan

that is actually at risk. If a borrower defaults but the lender realizes from sale of

assets of the borrower the full amount of its loan, then the loan is risk-less and no

capital is needed to cushion the bank against losses. Capital is only needed to the

extent that default is accompanied by loss.

PD is estimated for each grade of loans. Correlation, , does not appear

explicitly in equation [1] but is, together with PD, imbedded in the terms KV and

MATA and will be discussed below.

Observation 1: The IRB does not compute a capital charge for a bank based

on the banks own internal model. Banks use their internal ratings of

borrowers only to categorize borrowers credit classes and, within each class,

credit grades. Internal bank estimates of PD, LGD and EAD are plugged into

the IRB formula to obtain regulatory capital.

3.

The Vasicek formula forms the heart of the IRB formula [14]. Named after

Oldrich Vasicek, co-founder with Stephen Kealhofer and John Andrew McQuown of

KMV Corporation, a leading commercial developer of standards and procedures for

measuring and pricing bank credit risk6, the Vasicek formula, also called the

asymptotic single risk factor approach [11] is

N 1 PD V N 1 q

KV N

1 V

[2]

Where:

N

N-1

= the level of confidence with which one wishes to establish that the

The Vasicek formula specifies the level of capital (expressed as a percent of

EAD) that is required to prevent the bank from going bankrupt in one year with a

probability of no more than (1-q), assuming that the loan generates no income and,

when a loan goes into default, there is no recovery (i.e., LGD=1). In other words if

one set q=.999 (as specified in Basel II) and if the Vasicek formula were an accurate

reflection of reality, one would expect that a typical compliant bank would have an

approximately even chance of going bankrupt once in 693 years.7

6

The formula has not achieved the exposure it deserves partly because it was developed for

commercial purposes. The abstract states This is a highly confidential document that contains

information that is the property of KMV Corporation. This document is being provided to you under

the confidentiality agreement that exists between your company and KMV. This document should only

be shared on a need to know basis with other employees of your business. [14]

7

Probability of survival in each year is 0.999. Observations are independent. 0.999693 = 0.4999, so

693 years elapse before the probability that the bank survives in all years first drops below 50%.

The Vasicek formula assumes that firm asset returns are normally distributed;

however, economic variables seldom exhibit normality. The Vasicek formula is a

single factor model: portfolio risk springs only from a single, economy-wide risk

factor. One might proxy such a single factor by real GDP growth. Yet if we examine

from mid-year 1921 through mid-year 2003 real US GDP growth for example (see

figure 1), we reject the normality assumption8.

[Insert figure 1 here]

Observation 2: Requiring a capital cushion that uses a q=.999 would be far

in excess of most regulators actual requirements if the Vasicek formulas

statistical assumptions approximated reality. A high q is required because the

assumption of normality in the model is flawed.

In the formula, the credit risk of each borrower is expressed as an annual PD.

Each borrower in a credit grade of a class is assumed to be initially identical, with

assets whose values change through time as they are buffeted continuously by shocks

(uncorrelated through time but correlated across borrowers) drawn from a stable,

normal distribution. If the value of assets of a borrower falls below the borrowers

debt, default occurs. Thus PD captures the leverage of the borrowers.

The Basel Committee refers to the Vasicek formula as a so-called Mertonstyle model 9 following Merton [15], who shows that the value of the equity of a

firm equals the value of an in-the-money Black-Scholes model option to purchase the

assets of the firm for the face value of the firms debt. Like Mertons formula, the

Vasicek formula models the assets of borrowing firms as random walks in continuous

time. Bankruptcy occurs when, at option expiry, the value of the assets of the

borrower is less than the face value of the debt of the borrower. But Merton is

8

The real GDP growth series is left skewed (-.94) and fat-tailed (kirtosis = 5.64). The Jarque-Bera

statistic is 37 leading to rejection of normality at the 0.000000 level of confidence.

9

See [7] clause 172.

default on the debt. Merton looks at a single firm in isolation, whereas Vasicek is

interested in the properties of a portfolio of debt held by a bank.

Assume that a part of a loan portfolio (i.e., a credit risk grade within one of the

up to 14 different loan classes) is composed of n loans to n identical borrowers. The

number of borrowers is large, so the portfolio is perfectly diversified. Each of the

borrowers has a very simple capital structure: it has a single asset and a single

liability. The borrowers are all solvent with assets greater than liabilities at time t=0

but as time progresses the value of each of the n borrowers assets changes, with the

values of each of the borrowers assets changing by a different amount. At the end of

a given period of time (in the IRB formula, it is one year), some portion of the

portfolios n borrowers has slid into insolvency: those insolvent borrowers liabilities

exceed their assets. The objective of the Vasicek formula is to determine the

proportion of borrowers that, by the end of the year, have become bankrupt. Since, in

the Vasicek formula, LGD = 1, that proportion of borrowers constitutes Kv.

Critically, each borrowers asset value change is positively correlated with

each other borrowers asset value change: their correlation coefficient is V . If V =

0 , given that the portfolio is perfectly diversified, each portfolio would be riskless.

By riskless, we mean that there would be no variance around the expected proportion

PD of the portfolio that becomes insolvent over the year. However, the fact that V >

0 means that the systematic risk component of each borrowers asset returns cannot be

diversified away. We therefore wish to specify an amount Kv that constitutes the

proportion of n borrowers that are expected be insolvent after the end of one year in a

10

bad state of the economy, where we are 99.9% certain that such a bad state of the

economy will not occur.

Below, we solve for the probability that any given borrower will go bankrupt

in the bad economic state. This is the solution of the conditional probability of default

of a single borrower. Because all borrowers are the same, this conditional probability

is identical to the expected proportion of defaults in the portfolio, conditional on the

poor state of the economy. We then demonstrate that this expected proportion in the

poor state of the economy can be interpreted as the proportion of portfolio at risk in a

value at risk (VAR) sense.

The Conditional Probability of Default of a Single Borrower. We consider

a one-period model. Borrower assets are viewed at t = 0 and again, one year later10.

Let y be the random element in the percent change in value of assets for a single

borrower over a one year horizon. This change is made up of two parts

e and ,

y

V e 1 V

In equation [3],

[3]

Although PD is the unconditional probability of default of a single borrower,

we assume that all borrowers are the same, so PD is also the proportion of borrowers

in a portfolio we would expect to default, given that we have no further information

about the state of the economy. PD P( y ) is the probability that the percent

change in the value of the borrowers y is less than the critical value , the point at

10

The Merton model uses continuous time asset value change. For a demonstration that the continuous

time model reaches the same conclusion as the simple, one period model presented here, contact the

authors.

11

which a borrower becomes insolvent and defaults. We can determine the value of

if we know the value PD by taking the inverse normal of the probability of default

N 1 ( PD) to obtain the critical value of default. For example, if the borrower

N 1 (.02) 2.053 .

PD gives the unconditional probability of default, which is a function of two

random variables. But we wish to focus on the conditional the probability of default

under the assumption that the economy is in a bad state. Figure 2 shows the normal

density function of the states of the economy over the (one year) period of interest,

where economic performance is measured only by the normalized random variable e.

The expected value of e is zero, but we set e = u, a bad state that would occur with

probability 0.001. Substituting for y from equation [3]:

P( y | e u) P( V e 1 V | e u )

[4]

V u

P ( y | e u ) P

1 V

Substituting for

[5]

using the cumulative standard normal distribution

N 1 ( PD) V u

P( y | e u ) N

1 V

[6]

The reader will note that equation [6] differs only slightly from [2] which we restate

below:

12

N 1 PD V N 1 q

KV N

1 V

[2 (restated)]

was expressed as a percent confidence that the capital in the bank is sufficient. In the

case where Basel II specifies that q = 99.9%, N 1 q 3.09 as in figure 2. In

equation [6], u is directly reported as the number of standard deviations away from

the mean of a standard normal distribution going to the left (x moving in an

unfavorable direction.). With this interpretation, the two equations are the same.

13

Although we have shown that the Vasicek formula equals the probability of default of

a single borrower given that the bad state of the economy u has occurred, we have not

demonstrated its applicability to a large portfolio of (identical) loans. For such a

demonstration, one can reason as follows. Each has the same conditional probability

of default. As the number of identical loans in the portfolio rises, the variance around

the proportion of loans defaulting within the portfolio should drop by the law of large

numbers11. Vasicek [14] formalizes this intuition by calculating the probability

distribution of the proportion of loans in the portfolio in default. Although we will not

repeat his derivation here, he shows that if the banks loan portfolio is infinitely fine

grained (when the number of loans increased to an arbitrarily high number), the

probability that the actual proportion of loans in default and hence the proportion of

assets lost (assuming, as we have throughout, that loss given default is complete)

would exceed some agreed level of capital, KV ,has the cumulative distribution

function (CDF) as follows [16]

F ( K v ) N

1 V N 1 K V N 1 p

[7]

We plot this CDF for the unconditional PD of two percent (PD = 2%) and six

values of V from 0.1 percent to 30 percent in figure 3. It shows that an 8 percent

capital ratio would only provide adequate capital, where adequate is defined as

being sufficient 99.9 percent of the time, if the asset correlation is 5 percent or less.

[Insert figure 3 here]

One can interpret the schedules in figure 3 as the VARs of the loan portfolio

(given on the x-axis) associated with a level of confidence given by the CDF function

11

See Gordy [10] and Wilde [17] for conditions under which assumptions of identical PD and exposure

amount can be dropped.

14

on the y-axis.

5.

The Single Factor Assumption. The Vasicek formula is a single factor

model: borrowers assets change in value through the impact of only two types of risk,

borrower-specific idiosyncratic risks and a single economy-wide systematic risk. The

model derivation shows that, because of portfolio diversification in bank assets, only

the economy-wide systematic factor requires bank capital to protect the bank against

borrower risk.

The Capital Asset Pricing Model (CAPM) is also a single factor model, but

CAPM is used to calculate the expected returns of equity securities as a function of

risk, not to determine the VAR of a debt portfolio [18]. Like the Vasicek formula,

CAPM demonstrates that, because of portfolio diversification, only one component of

risk counts: economy-wide systematic risk, which CAPM measures with beta.

Unfortunately, empirical tests of realized stock returns show that the market prices

multiple risks: a single factor model such as CAPM performs poorly in explaining

observed stock returns [19]. If a single-factor fails to explain asset returns in the

relatively efficient public equity markets, it is not likely to be more appropriate in

private debt markets.

Commercial credit risk models typically do not make the single factor

assumption. CreditMetrics uses credit rating migration probabilities of each obligors

cash flows and tables of joint probability of migration [20]. Creditrisk+ uses a (small)

number of sectors with a single risk factor in each sector [21]. Moodys-KMV in its

Portfolio ManagerTM software has about 110 factors that the user can specify in

determining obligor returns [11]. Few bankers would suggest that the only risk in

15

their loan portfolios arose from a single, undiversifiable, residual, leveraged, global

factor. Given this lack of theoretical and industry support, it is noteworthy that Basel

II received virtually no criticism of the single factor assumption. The paradox is

resolved by the need for portfolio-indifference. Neither regulators nor bankers would

accept a model that charged different banks different regulatory capital requirements

for the same loan. Yet, without the single factor assumption, an asset in one portfolio

would require (in terms of VAR) a different amount of capital from the same asset in a

different portfolio because the covariances of the asset with the two portfolios would

tend to differ. The only theoretically consistent basis for requiring that every bank

portfolio hold the same percent of risk capital for a given asset is a one-factor risk

model where all portfolios are assumed to be perfectly diversified with respect to all

but that one (undiversifiable) risk.

Observation 3: The theoretical justification for the single factor model is

weak and does not correspond to best practice in the banking industry. It

represents a compromise that allows identical capital charges for identical

risk positions in diverse banks to be theoretically justified.

Granularity. Lack of diversification historically has been one of the main

causes of bank distress, yet IRB assumes that banks have infinitely fine-grained

portfolios. Not only is this unlikely to be true in practice: it is not even desirable as a

bank objective.

and introduced a granularity adjustment in 2001 [5,17,22]. Comprising the most

complex part of that first detailed draft of Basel II, it was dropped without comment

from subsequent drafts, most likely because of its complexity. The issue of

granularity remains in Basel II as a set of provisions under Pillar 2 for banks to review

16

Observation 4: The complexity of IRB is far less than that deemed by risk

management professionals to be sufficient to capture imperfectly diversified,

portfolio-specific, aspects of credit risk.

Calculating Correlations. As figure 3 illustrates, the correlation between

changes in asset values over time of the representative firms in a portfolio is a critical

parameter in the IRB approach. As the correlation decreases, the VAR of the portfolio

drops. As V approaches zero in a portfolio with PD = 2%, the CDF approaches a

vertical line at 2 percent. If V =0, there would be no risk in the portfolio and the only

capital that would be required would be for expected losses, in this case, 2 percent of

the portfolio. Since such losses, being expected, would already be provided for, KIRB

subtracts off PD from KV in equation [1], leaving no capital required. Investigating

larger correlations between asset returns of the representative borrowers, if V = 0.30

an 8 percent capital cushion would be woefully inadequate since the CDF at 8 percent

would be 94.6 percent: with a 5.4 percent probability in a one year period, the banks

capital would be insufficient to sustain losses.

Unfortunately, V is a parameter that is impossible to observe directly:

theoretically it is the correlation expected to prevail in future; correlations evolve over

time and actual correlations are likely to be multi-factored and varying between

borrowers [23]. Moreover, unlike publicly traded shares, the assets of most bank

borrowers have no available historical series from which to estimate correlations.

One can, however, use stock returns and the market model to estimate V .

We show below that equation [3] is a standardized form of the market model:

12

17

ri i i rm i

[8]

rm = the return rate of market portfolio

ri i i E (rm )

r E (rm ) ( i ) i

( i m ) m

i

i

m

i ( i )

[9]

where i , m , ( i ) are the standard variance of i-th asset, the return rate of market

portfolio and the random error, respectively.

If y

ri i i E (rm )

rm E (rm )

i

,e

,

, then the variables y, e, are

i

m

( i )

normalized random variables and their variances satisfy the following equation

1 ( i

m 2 ( i ) 2

) (

)

i

i

Letting V ( i

y

[10]

m 2

) , we obtain equation [3] from the equations [9] and [10].

i

V e 1 V

In linear regression, i

[3 (restated)]

im

im

and i

; therefore, the term usually referred to

2

m i

m

i V

[11]

In other words, the correlation between the separate borrows returns is the square of

the correlation between each of the borrowers returns and the single, common,

systematic risk factor.

18

If one accepts the analogy of the market risk in CAPM with the systematic risk

in the Vasicek formula, one can roughly estimate V using widely available data13:

m = 20 percent per annum; the average stock volatility is i = 46 percent per

2

v i i m

i

2

0.435 0.189 ; V 19 percent.

[12]

should note a potential confusion: V is the correlation coefficient between

borrower asset returns and, therefore, is the square of the correlation of asset

returns with the systematic factor14.

The first complete draft of Basel II used a single correlation, V = 20 percent,

a value very close to the 19 percent we calculated above [5]. The selection of 20

percent, however, occasioned immediate, intense debate. Banks protested that the

true correlations of retail and SME portfolios were considerably below 20 percent and

that, if implemented, such a high correlation coupled with the higher probabilities of

default in the retail and SME portfolios would lead banks to reduce their lending to

retail and SME sectors. Now Basel IIs correlations are lower and more flexible,

varying between values lower and upper according to equation [13] with calculated

values in table 1:

V lower upper lower e 50 PD SME

13

[13]

We obtain data from Damodarans website [24]. We use the standard deviation of equity market

returns from 1928 through 2002 from the spreadsheet Annual Returns on Stock, T.Bonds and T.Bills:

1928 Current and the average asset volatilities of from his spreadsheet Firm Value and Equity

Standard Deviations (for use in real option pricing models) market.

14

Some related models specify the risk process as correlation with the common risk factor where asset

returns are y e 1 2 . See [25,26,27].

19

where SME is the small and medium sized borrower adjustment, applicable only to

firms with less than euros 50 million15. The SME adjustment is:

S 5

SME 0.04 1

45

[14]

where S is the size of the borrower measured by annual sales in millions of euros. In

equation [13] increases in PD lead to decreases in V . Figure 4 shows that, for PD

ranging from 0.01 percent to 7.00 percent, the weight on the lower value correlation

lower ranges between 0.5 percent and 97 percent.

The SME adjustment reduces V by up to 4.8 percent. Effects of these adjustments

are given in Table 1 below.

Theory gives little guidance as to the value of V [11]. Lopez calculates

values of V implied by empirical observations of portfolio defaults. He finds

support for the ranges of V suggested in Basel II, confirms that borrowers with

higher probabilities of default have lower V , and concludes that asset return

correlations are higher between healthy firms in normal operations but that firms tend

to succumb to distress for idiosyncratic reasons, leading to V falling as the

probability of default rises. He also finds that size affects correlations, with larger

firms asset returns being more correlated than smaller firms. His findings, then,

support Basel IIs parameterizing of V .

15

1 e 50 PD

50

1 e

V lower

1 e 50 PD

upper

1 e 50

20

-50

SME but as Credit Suisse points out, e is

theoretical guidelines; however, modeling V as an inverse function of PD

between prescribed upper and lower limits (adjusted for small firms) has

empirical support.

[Insert table 1 here]

6. Adjustments in IRB Formula for Loss Given Default, Expected Loss and

Maturity

Loss Given Default. One of the innovations of Basel II is its explicit

recognition of different levels of LGD in different portfolios. Banks under advanced

IRB calculate their own LGDs and input them into equation [1]. The product of [Kv

PD] and LGD determines the percent of capital required. Calculating KV, PD and

LGD separately, however, implies that PD and LGD are independent. Yet experience

teaches that the value of collateral on a loan is inversely related to the probability of

default on the loan. This inverse relationship is borne out both theoretically and

empirically [26,27,29,30].

Observation 7: The assumption that LGD and PD are uncorrelated is made

to simplify the IRB model, and has neither theoretical nor empirical support.

Use of the assumption is likely to result in underestimation of required capital.

The Pro-cyclicality of Loss Given Default and Probability of Default. Procyclicality in setting capital requirements is the tendency for capital requirements to

increase during long recessions and decrease during long booms. In IRB, there are

two sources of pro-cyclicality. First, Basel II prescribes that estimates of PD, LGD

and EAD be obtained from five year horizons yet five years is less than a full

economic cycle. Second, pro-cyclicality may result from periodic credit reviews, if

21

predominates in periods of strong economic growth.

Allen and Saunders review the literature concerning this problem, as well as

the related problem of correlations between PD, LGD and EAD and find near

unanimity that credit risk measurement models in banking accentuate pro-cyclicality,

increasing the volatility of economic cycles [31]. They observe, however that all

regulatory regimes that specify capital adequacy share the same problem. A PD

model can avoid pro-cyclicality only by being inconsistent over time, i.e., by failing

to assign higher PD's when, for example, the current credit quality of a corporate has

declined given economic forecasts. Borrowers have poorer prospects in recessions

and banks and regulators recognize this by implementing higher loan loss reserves,

regardless of the sophistication of the capital adequacy regime.

Observation 8: The use of recent historic data as inputs to the IRB and

periodically updated probabilities of default based on time consistent

assessments of creditworthiness of borrowers increase required capital during

recessions, potentially exacerbating the credit cycle.

Expected Loss. KIRB calculates capital required for unexpected losses by

taking the Vasicek formulas calculation of KV (the capital required for both expected

and unexpected losses) and subtracting from it PD, the capital required for expected

losses. Banks provide for expected losses through the spread charged over cost of

funds and loan loss reserves.

Banks book loans in the expectation of profit but with the knowledge that a

portion of the loans will default. To avoid loss from a risky portfolio of loans, a bank

must set the total spread over cost of funds to be no less than the portion of the

portfolio that is expected to default. Roughly speaking, if PD = 2%, and the bank

22

charges two percent over the cost of funds and two percent of the portfolio defaults,

then the bank just breaks even (assuming LGD = 1). IRBs treatment of capital for

expected losses is consistent with the statistical interpretation of expected losses being

covered by expected spread income16.

Banks also maintain general loan loss reserves which commonly deviate from

the statistical expectation of loan losses (EL):

EL = PD x LGD x EAD

[15]

A bank may use loan loss reserves as a quasi-equity cushion, a means of reducing

taxes, a smoothing device for income or a provision for portfolios whose losses may

exceed the spread income described above. The use of loan loss reserves, moreover,

can differ considerably from bank to bank, country to country and time to time.

General loan loss reserves have traditionally been a part of Tier II capital (up

to a ceiling of 1.25 percent); however, under Basel II, IRB banks are not allowed this

use of general loan loss reserves. Instead they calculate EL as given above and, if

general loan loss reserves are less than EL, they must subtract the difference from

capital. If general loan loss reserves are more than EL, IRB banks can use the

difference as part of Tier II capital to the extent that it does not exceed 0.6 percent of

credit risk weighted assets 17. The calculations of EL and its netting from loan loss

reserves are made without reference to expected spread income.

Observation 9: The requirement that loan loss reserves be aligned with EL

institutionalizes a double counting, whereby EL are covered as a matter of

pricing by the spread over the cost of funds as well as by loan loss reserves

which under IRB must be no less than EL. This may penalize high EL lending

(such as retail and credit card lending).

16

In the initial drafts of Basel II only 75 percent of PD in only one class of loans, revolving retail loans,

was added back in what was called the future margin income adjustment [5,6].

17

See [1] clauses 43, 375, 380-383 and 386.

23

Maturity. The final adjustment in the IRB formula is the adjustment for the

average maturity, MATA in equation [1] above. That adjustments is given as

MATA

1 ( m 2.5)b( PD)

1 1.5b( PD )

[16]

where b(PD) =

maturity

adjustment

function

tP

m

P

Pt

The Vasicek formula calculates capital for a one-year horizon. Since a longer

maturity loan to a borrower merits a higher capital charge than a shorter maturity loan

to the same borrower, IRB adjusts Vasicek for maturity. The adjustment accounts for

the potential for credit deterioration being larger for higher rated credits than for lower

rated credits that have a potential not only for deterioration but also for improvement.

Figure 5 shows how equation [14] adjusts for four different PDs.

In the consultation rounds of Basel II, the MATA adjustment incurred only one

consistent criticism from bankers: adjustments for very short-term facilities are

insufficient. Using the 0.5 percent probability of default, for example, MATA would

allow a risk adjustment of only 0.78 of for a loan with zero maturity when, in the view

of most bankers, such a facility would be essentially risk-less [32].

Observation 10: The adjustment for maturity is in accord with industry

practice; however, it allows insufficient reduction of required capital for very

short term facilities.

24

6.

Conclusion

The IRB is a hybrid between a very simple statistical model of capital needs

for credit risk and a negotiated settlement. The statistical model used is not best

practice today and certainly will not become so in the future. Given the constraints

of the regulatory environment and the rapid development of risk management,

however, regulators would be unable impose a uniform best practice solution onto

all banks. Our observations reinforce the Basel Committees view that the IRB is

work-in-progress and will remain so long after the implementation of Basel II18.

18

25

References

[1] Basel Committee on Banking Supervision. International convergence of capital

measurement and capital standards: a revised framework. Basel; June 2004.

[2] Jorion, P. Value at risk. McGraw Hill, New York; 2001.

[3] Basel Committee on Banking Supervision. International convergence of

capital measurement and capital standards. Basel Committee Publications No. 4, Bank

for International Settlements, Basel; July 1988.

[4] Basel Committee on Banking Supervision. A new capital adequacy framework.

Basel Committee Publications No. 50, Basel; June 1999.

[5] Basel Committee on Banking Supervision. The new Basel capital accord:

Consultative document issued for comment by 31 May 2001. Basel; January 2001.

[6] Basel Committee on Banking Supervision. The new Basel capital accord:

Consultative document issued for comment by 31 July 2003. Basel; April 2003.

[7] Basel Committee on Banking Supervision. The internal ratings based approach:

Consultative document: supporting document to the new Basel capital accord issued

for comment by 31 May 2001. Basel; January 2001.

[8] Basel Committee on Banking Supervision. Potential Modifications to the

Committees Proposals. Press release. Basel; 5 November 2001.

[9] Gordy, M.A comparative anatomy of credit risk models. Journal of Banking and

Finance 2000; 24 (1-2): 119-49.

[10] Gordy, M. A risk factor model foundation for ratings based capital rules. Board

of Governors of the Federal Reserve System working paper 2002.

[11] Lopez, JA. The empirical relationship between average asset correlation , firm

probability of default and asset size. Economic Research Department, Federal Reserve

Bank of San Francisco 2002.

[12] Wilde, T. IRB approach explained. Risk. May 2001: 87-90.

[13] British Bankers Association and the London Investment Banking Association.

Response to the Basel Committees Second Consultation on a new Basel Accord. May

2001. Available from http://www.bis.org/bcbs/ca/bribanass.pdf.

[14] Vasicek, O. Probability of loss on loan portfolio. KMV Corporation. 1987

Available from www.moodyskmv.com/research/portfoliotheory.html.

[15] Merton, RC. On the pricing of corporate debt: The risk structure of interest rates.

The Journal of Finance 1974; 29(2): 449-70.

[16] Vasicek, O. Limiting loan loss probability distribution. KMV Corporation 1991

26

[17] Wilde, T. Probing granularity. Risk August 2001: 103-6.

[18] Sharp, W. Capital asset prices: a theory of market equilibrium under conditions

of risk. Journal of Finance 1964; 19: 425-42.

[19] Fama, E and French, K. The cross-section of expected stock returns. The

Journal of Finance 1992; 47(2): 427-65.

[20] Riskmetrics. CreditMetrics Technical Document. Riskmetrics. April 2, 1997.

Available from http://www.riskmetrics.com/cmtdovv.html.

[21] Credit Suisse First Boston. Creditrisk+: a credit risk management framework.

Available from http://www.csfb.com/creditrisk .

[22] Gourieroux, C, Laurent, JP and Scaillet, O. Sensitivity analysis of values at risk.

Journal of Empirical Finance 2000; 7: 225-45.

[23] Chan, L Karceski, J and Lakonishok, J. On portfolio optimization: forecasting

covariances and choosing the risk model. Review of Financial Studies 1999; 12(5):

937-74.

[24] Damodaran, A. Damodaran Online. Available from

http://pages.stern.nyu.edu/~adamodar

[25] Rosen, D and Sidelnikova, M. Understanding stochastic exposures and LGDs in

portfolio credit risk. ALGO Research Quarterly 2002; 5(1): 43-5.

[26] Frye, J. Collateral damage. Risk April 2000: 91-4.

[27] Frye, J. Depressing recoveries. Risk. November 2000: 108-11.

[28] Credit Suisse. Credit Suisse Group CP3 Comments. 2003. Available from

www.bis.org.

[29] Frye, J. A false sense of security Risk August 2003: 63-7.

[30] Altman, E, Resti, A and Sironi, A. Analyzing and explaining default recovery

rates. ISDA Report December 2001. Also available as BIS working paper, no 113.

[31] Allen, L and Saunders, A. A survey of cyclical effects in credit risk measurement

models. BIS Working Papers No. 126: January 2003.

[32] Risk Management Association. Response to the US Banking Agencies advance

notice of proposed rulemaking regarding new risk-based bank capital rules. Board of

Governors of the Federal Reserve 2003. Available from

http://www.federalreserve.gov.

27

Figure 1

Frequency of US Annual Real Growth Rates

14

12

frequency

10

28

0.45

0.4

0.35

0.3

Good states

Bad states

0.25

0.2

0.15

0.1

0.05

Normalized economic

growth rate exceeded with

99.9% probability e = u = -3.09

state of economic growth

29

Normalized average

Growth rate e = 0

4.9

4.7

4.4

4.2

4.0

3.7

3.5

3.3

3.0

2.8

2.6

2.4

2.1

1.9

1.7

1.4

1.2

1.0

0.7

0.5

0.3

0.1

-0.2

-0.4

-0.6

-0.9

-1.1

-1.3

-1.6

-1.8

-2.0

-2.2

-2.5

-2.7

-2.9

-3.2

-3.4

-3.6

-3.9

-4.1

-4.3

-4.5

-4.8

-5.0

Figure 3

30

31

Probability of Default

0.068

0.066

0.064

0.062

0.060

0.057

0.055

0.053

0.051

0.049

0.046

0.044

0.042

0.040

0.038

0.035

0.033

0.031

0.029

0.026

0.024

0.022

0.020

0.018

0.016

0.013

0.011

0.009

0.007

0.005

0.002

0.000

Figure 4

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

Table 1

Correlations and maturity adjustments

Exposure

lower

upper

Sovereign,

corporate

and bank

SMEs

0.12

0.24

0.12 minus

0.0 to 0.04

0.12

0.24 minus

0.0 to 0.04

0.30

Yes

0.15

No

0.04

No

0.16

--

Highly

Volatile

Commercial

Real Estate

Residential 0.15

Mortgage

Revolving

0.04

Retail (eg.,

credit

cards)

Other Retail 0.03

Exposures

Y: maturity

adjust

ment

Yes

Yes

32

Figure 5

33

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