Capital Allocation for Portfolio Credit Risk

FDIC Center For Financial Research Working Paper No. 2006-08, Revision of WP2005-04

34 Pages Posted: 1 Apr 2005

See all articles by Paul Kupiec

Paul Kupiec

American Enterprise Institute

Multiple version iconThere are 2 versions of this paper

Date Written: August 2006

Abstract

Capital allocation rules are derived that maximize leverage while maintaining a target solvency rate for credit portfolios where risk is driven by a single common factor and idiosyncratic risk is fully diversified. Equilibrium conditions ensure that capital allocations depend on interest earnings as well as credits' probability of default, endogenous loss given default, and asset correlation. Capitalization rates exceed those estimated using Gaussian credit loss models. Results demonstrate that credit risk is undercapitalized by the Basel II AIRB approach in part because of ambiguities regarding the definition of loss given default. An alternative proposed capital rule removes this bias.

Keywords: economic capital, credit risk internal models, Basel II Internal Ratings Approach

JEL Classification: G12, G20, G21, G28

Suggested Citation

Kupiec, Paul, Capital Allocation for Portfolio Credit Risk (August 2006). FDIC Center For Financial Research Working Paper No. 2006-08, Revision of WP2005-04, Available at SSRN: https://ssrn.com/abstract=681261 or http://dx.doi.org/10.2139/ssrn.681261

Paul Kupiec (Contact Author)

American Enterprise Institute ( email )

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