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The empirical relationship between average asset correlation, firm probability of default and asset size

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  • Jose A. Lopez

Abstract

The asymptotic single risk factor (ASRF) approach is a simplified framework for determining regulatory capital charges for credit risk and has become an integral part of how credit risk capital requirements are to be determined under the second Basel Accord. Within this approach, a key regulatory parameter is the average asset correlation. In this paper, we examine the empirical relationship between the average asset correlation, firm probability of default and firm asset size measured by the book value of assets by imposing the ASRF approach within the KMV methodology for determining credit risk capital requirements. Using data from year-end 2000, credit portfolios consisting of U.S., Japanese and European firms are analyzed. The empirical results suggest that average asset correlation is a decreasing function of probability of default and an increasing function of asset size. When compared with the average asset correlations proposed by the Basel Committee on Banking Supervision in November 2001, the empirical average asset correlations further suggest that accounting for firm asset size, especially for larger firms, may be important. In conclusion, the empirical results suggest that a variety of factors may impact average asset correlations within an ASRF framework, and these factors may need to be accounted for in the final calculation of regulatory capital requirements for credit risk.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2002-05.

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Date of creation: 2002
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Handle: RePEc:fip:fedfwp:2002-05

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Keywords: Risk management;

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  1. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
  2. Michael B. Gordy, 2000. "Credit VAR and risk-bucket capital rules: a reconciliation," Proceedings 685, Federal Reserve Bank of Chicago.
  3. Beverly J. Hirtle & Mark Levonian & Marc Saidenberg & Stefan Walter & David Wright, 2001. "Using credit risk models for regulatory capital: issues and options," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Mar, pages 19-36.
  4. Simonne Varotto, 2001. "Credit Risk Diversification," ICMA Centre Discussion Papers in Finance, Henley Business School, Reading University icma-dp2001-07, Henley Business School, Reading University.
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