Asset return correlation in Basel II: implications for credit risk management
AbstractThe Basel Committee is currently reviewing the Accord on capital adequacy. It should provide new approaches that are more sensitive to risks. This paper focuses on the Internal Rating Based Advanced approach for retail exposures, which is compared to a one systematic factor model in order to highlight the underlying hypotheses of Basel II. The Basel framework assumes that the asset return correlation is solely determined by the probability of default (PD). However, the one-factor model highlights the influence of the volatility of PD on the asset return correlation, especially for low PDs. The assumption of the Basel framework implies first that there may be opportunities for regulatory arbitrage. Second, as the regulatory capital curve is concave in PD, it gives an incentive to decompose the portfolio into segments only for reducing the capital requirement. Finally, the inaccurate measure of asset return correlation might be misleading for credit risk management. The Basel framework is applied to a large portfolio of retail contracts (35,787 individual automotive lease contracts) provided from a major European financial institution. We show that the outcomes of Basel II are empirically relevant.
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Bibliographic InfoPaper provided by ULB -- Universite Libre de Bruxelles in its series Working Papers CEB with number 04-017.RS.
Length: 34 p.
Date of creation: Apr 2004
Date of revision:
Publication status: Published by: Université Libre de Bruxelles, Solvay Business School, Centre Emile Bernheim (CEB)
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More information through EDIRC
credit risk; Basle II; asset correlation;
Find related papers by JEL classification:
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-02-05 (All new papers)
- NEP-BEC-2006-02-05 (Business Economics)
- NEP-FIN-2006-02-05 (Finance)
- NEP-FMK-2006-02-05 (Financial Markets)
- NEP-REG-2006-02-05 (Regulation)
- NEP-RMG-2006-02-05 (Risk Management)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Michael B. Gordy, 1998.
"A comparative anatomy of credit risk models,"
Finance and Economics Discussion Series
1998-47, Board of Governors of the Federal Reserve System (U.S.).
- Altman, Edward I, 1989. " Measuring Corporate Bond Mortality and Performance," Journal of Finance, American Finance Association, vol. 44(4), pages 909-22, September.
- Schmit, Mathias, 2004. "Credit risk in the leasing industry," Journal of Banking & Finance, Elsevier, vol. 28(4), pages 811-833, April.
- Sironi, Andrea & Zazzara, Cristiano, 2003. "The Basel Committee proposals for a new capital accord: implications for Italian banks," Review of Financial Economics, Elsevier, vol. 12(1), pages 99-126.
- Stéphanie Duchemin & Marie-Paule Laurent & Mathias Schmit, 2003. "Asset return correlation: The case of automotive lease portfolios," Working Papers CEB 03-007.RS, ULB -- Universite Libre de Bruxelles.
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