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On Deficiencies and Possible Improvements of the Basel II Unexpected Loss Single-Factor Model

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Abstract

The goal of the Basel II regulatory formula is to model the unexpected loss on a loan portfolio. The regulatory formula is based on an asymptotic portfolio unexpected default rate estimation that is multiplied by an estimate of the loss given default parameter. This simplification leads to a surprising phenomenon where the resulting regulatory capital depends on a definition of default that plays the role of a frontier between the unexpected default rate estimate and the LGD parameter, whose unexpected development is not modeled at all or is modeled only partially. We study the phenomenon in the context of single-factor models where default and loss given default are driven by one systematic factor and by one or more idiosyncratic factors. In this theoretical framework we propose and analyze a relatively simple remedy of the problem requiring that the LGD parameter be estimated as an appropriate quantile on the required probability level.

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Bibliographic Info

Article provided by Charles University Prague, Faculty of Social Sciences in its journal Finance a uver - Czech Journal of Economics and Finance.

Volume (Year): 60 (2010)
Issue (Month): 3 (August)
Pages: 252-268

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Handle: RePEc:fau:fauart:v:60:y:2010:i:3:p:252-268

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Keywords: credit risk; correlation; recovery rate; regulatory capital;

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Cited by:
  1. Martin Mandel & Vladimír Tomšík, 2011. "Regulation of the Banking Sector From the Economic Theory´s Point of View," Politická ekonomie, University of Economics, Prague, vol. 2011(1), pages 58-81.

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