Default Risk Charge: Modeling Framework for the 'Basel' Risk Measure

Abstract

As a result of the Basel Committee on Banking Supervision’s Fundamental Review of the Trading Book, revised standards for capital requirements for market risk in banks’ trading books have been issued. Under the new standards, default risk needs to be measured and capitalized through a dedicated default risk charge (DRC). Although quantitative impact studies are ongoing and banks are preparing for these regulatory changes, this paper is the first to present a modeling framework for the DRC measure that projects losses over a one-year capital horizon at a 99.9% confidence level. We discuss selected risk factor models, which we use to derive simulation-based loss distributions and associated default risk figures. The model’s properties, aspects of its implementation and a comparison with the standardized approach for default risk are explored through the use of example portfolios.

Keywords: banking regulation, risk modeling, market risk, Fundamental Review of the TradingBook (FRTB), default risk charge (DRC)