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Basel II and Internal Ratings

To secure a minimum level of solvency even in adverse conditions, regulators require banks to hold a certain, specified amount of equity capital which serves to cushion losses from risky activities. These capital requirements are a cornerstone of bank regulation.

Credit risk, which is the main driver of risk for many banks, can differ substantially across individual loans and credit-risky instruments. The rules set out in the Basel I accord from 1988, however, showed little differentiation in the capital required to be held against loans. For every dollar lent to a corporation, regardless of whether it was rated AAA, CCC or unrated, banks were required to hold 8 cents in equity.

Therefore, one key motivation for reforming the Basel I accord was to make capital requirements more sensitive to the risk of an individual exposure. The new Basel II framework allows several approaches for measuring this risk. In the standardized approach, individual risk is measured through external agency ratings; each rating commands a certain risk weight that determines capital requirements. In the internal ratings-based (IRB) approach, which has a foundation and an advanced variant, individual risk is measured using banks' internal ratings.

In this chapter, we first show how to program the key formula of the IRB approach, which represents capital requirements as a function of a loan's default probability, loss given default and maturity. Subsequently, we explore the ...

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