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Basel Funda
Basel Funda
max( V ,0)
j 1
j
[max( V ,0) a L ]
j 1
j j j
To
N N
max( V j ,0) a j L j (0.4 0.6 NRR )
j 1 j 1
1996 Amendment
Implemented in 1998
k VaR SRC
Where k is a multiplicative factor chosen
by regulators (at least 3), VaR is the 99%
10-day value at risk, and SRC is the
specific risk charge for idiosyncratic risk
related to specific companies
Problem with Basel I
Regulatory arbitrage was rampant
Three pillars
New minimum capital requirements for
credit and operational risk
Supervisory review: more thorough and
uniform
Market discipline: more disclosure
New Capital Requirements
Risk weights based on either external credit
rating (standardized approach) or a banks
own internal credit ratings (IRB approach)
U i ai F 1 a Zi 2
i
Hence
N 1 Q (T ) a F
Prob(Ti T F ) N i i
1 ai2
Assuming the Q' s and a' s are the same for all companies
N 1 Q(T ) F
Prob(Ti T F ) N
1
where is the copula correlatio n
The Model continued
The worst case default rate for portfolio for a
time horizon of T and a confidence limit of X is
N 1[Q(T )] N 1 ( X )
WCDR(T,X) N
1
PD probability of default
EL EAD i LGD i PD
i
EAD
i
i LGD i (WCDR PD)
The Model Used by Regulators:
The loss probability density function and the
capital required by a financial institution
Expected X% Worst
Loss Case Loss
Required
Capital
0 1 2 3 4
Numerical Results for WCDR
PD=0.1% PD=0.5% PD=1% PD=1.5% PD=2%
Expected loss:
So jointly the banks have managed to reduce their capital required from
$80 to $18.60 a 70.6% fall.