A risk-factor model foundation for ratings-based bank capital rules
AbstractWhen 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.
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Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2002-55.
Date of creation: 2002
Date of revision:
Other versions of this item:
- Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
- NEP-ALL-2003-01-27 (All new papers)
- NEP-FIN-2003-01-27 (Finance)
- NEP-RMG-2003-01-27 (Risk Management)
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