Rating Granularity and Basel Ii Capital Requirements

21 Pages Posted: 5 Jan 2004

See all articles by Rainer Jankowitsch

Rainer Jankowitsch

WU (Vienna University of Economics and Business); Vienna Graduate School of Finance (VGSF)

Walter S. A. Schwaiger

Vienna University of Technology - Department of Accounting and Controlling

Stefan Pichler

WU - Vienna University of Economics and Business - Department of Finance, Accounting and Statistics; VGSF (Vienna Graduate School of Finance)

Date Written: August 2003

Abstract

In this paper we examine the influence of the granularity of a rating system on the resulting regulatory capital requirements with respect to the framework released by the Basel Committee on Banking Supervision (Basel II). We define granularity as the number of cohorts or rating classes used to measure default rates and the relative size of these cohorts, respectively. We show that due to the convex relation between capital requirements and estimated probabilities-of-default (PD) capital requirements decline with the fineness of the rating system and, moreover, that for a given number of rating classes there exists an 'optimal' granularity in terms of minimal capital requirements. We provide several numerical and empirical results to assess potential effects for rating systems of intermediate granularity (as commonly used by banks) and 'naive' schemes to construct the relative cohort sizes. As a benchmark result we obtain a 12 bp (45 bp) reduction in capital requirements when switching from five to ten rating classes and using the optimal ('naive') relative cohort sizes. These findings are confirmed by an analysis based on empirical data about more than 11,000 Austrian firms provided by Creditreform.

Keywords: Rating system, cohort method, Basel, banking regulation, capital requirements, probability of default, Beta distribution, Jensen's inequality

JEL Classification: G28, C13

Suggested Citation

Jankowitsch, Rainer and Schwaiger, Walter S. A. and Pichler, Stefan, Rating Granularity and Basel Ii Capital Requirements (August 2003). Available at SSRN: https://ssrn.com/abstract=436803 or http://dx.doi.org/10.2139/ssrn.436803

Rainer Jankowitsch

WU (Vienna University of Economics and Business) ( email )

Welthandelsplatz 1
Vienna, Vienna AT1020
Austria
+43 1 31 336 4340 (Phone)
+43 1 310 0580 (Fax)

Vienna Graduate School of Finance (VGSF) ( email )

Welthandelsplatz 1
Vienna, 1020
Austria

Walter S. A. Schwaiger

Vienna University of Technology - Department of Accounting and Controlling ( email )

Theresianumgasse 25
A-1040 Vienna
Austria

Stefan Pichler (Contact Author)

WU - Vienna University of Economics and Business - Department of Finance, Accounting and Statistics ( email )

Heiligenstaedter Strasse 46-48
Wien 1190
Austria

VGSF (Vienna Graduate School of Finance) ( email )

Heiligenstaedter Strasse 46-48
Vienna, 1190
Austria