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
There are 2 versions of this paper
Capital Allocation for Portfolio Credit Risk
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: Suggested Citation
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