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Basel II
Hugh Thomas
Zhiqiang Wang
Abstract
This paper describes the theoretical and institutional background to the formula
specified by the Bank for International Settlements Basel Committee on
Bankings internal-ratings based (IRB) approach to Pillar 1 of Basel II: minimum
capital requirements. The IRB formula is based on the Vasicek formula and is the
conditional probability of default of a single borrower with normally distributed
asset returns. We discuss the assumptions of the Vasicek formula and the
adjustments made to it in the IRB formula. From these discussions, we make 10
observations highlighting that the IRB formula does not correspond to industry
best practice, but represents a negotiated compromise to achieve simplicity,
portfolio invariance and bank acceptance of prescribed capital levels. The riskmeasurement implications of this compromise should be understood by regulators
and bankers in order to implement properly regulatory oversight, which
constitutes Pillar 2 of Basel II and by investors who will be should understand
disclosure requirements of Pillar 3.
Key words:
Basel II
Internal Ratings-Based Approach
Vasicek Formula
Bank Risk Capital
Bank Regulatory Capital
closely than under Basel I [3] . The Basel Committee worked from the late 1990s to
2004 on Basel II setting out first a general direction and then two detailed drafts
[4,5,6] responding to industry comments. The completed Basel II rests on three
pillars: minimum capital requirements, the supervisory review process and market
discipline, but among the three, the first is by far the most complex, taking up about
three quarters of the pages of Basel II. At the core of Pillar 1 is the IRB approach.
We refer to the 1988 Capital Accord, the amendment to incorporate market risks by the Basel
Committee in 1996 and Basel Committee publications 9, 12, 18 and 36 collectively as Basel I [3].
The Basel Committee has explained the philosophy of the IRB approach
[1,7,8]. Economists at central banks have compared commercially available credit
risk models from a statistical point of view and have used them to calibrate the IRB
approach [9,10,11]. Wide briefly explains the IRB approach from a risk management
approach [12]. Yet bankers have expressed strong reservations about the opacity of
the equations and their coefficient values in the IRB approach [13]. To address these
reservations, we discuss the motives for the IRB approach, the basis of the IRB
formula, the derivation of the Vasicek formula that lies within IRB formula,
adjustments in the IRB formula and issues of concern to those who will apply it the
single factor model, correlation, granularity, loss given default and maturity.
We focus discussion on the Advanced IRB approach. A major distinction between the Advanced and
the Foundations IRB approaches is that in the Advanced, banks supply internal estimates of both
probability of default and loss given default while in Foundations, regulators supply loss given default.
3
See [1] clause 15. The Committee sets as an objective that further movements towards accepting
internal bank models for setting bank capital adequacy standards are possible in future. See [1] clause
18
Prior to Basel II, regulators have not needed to understand modern risk
management. But under Pillar 2, regulators review the processes by which bankers
assess their own capital adequacy. This involves much more than confirming that
bankers have placed risk positions in appropriate buckets for the purpose of
calculating capital adequacy formulae. Banks implementing the IRB approach have
existing risk capital assessment criteria which differ considerably from the regulatory
capital calculations in the IRB approach. Without understanding the theoretical and
practical justification of the IRB formula, neither bank supervisors nor bankers can
assess the relative validity of regulatory and internal capital adequacy approaches.
Understanding the IRB approach is also important to investors. Under Pillar
3, banks will disclose new information about risk measurement and regulatory capital
requirements, with the greatest volume of such disclosures centering on the IRB
approach. The Basel Committee anticipates that the additional disclosure will
facilitate the markets assessment of bank capital adequacy. But such intelligent
assessment is possible only if investors understand that which is being disclosed.
2. Overview of the IRB Formula
The IRB formula is designed for the loan portfolios of large international
banks. To apply the IRB formula, each bank divides its assets into up to14 different
classes4. For thirteen of those of those classes all but equity stock the IRB
4
The 14 classes are composed of five major asset classes: corporate, sovereign, bank, retail and equity.
The major class corporate, in addition to standard lending to corporations, includes five classes of
specialized lending i.e., lending to special purpose entities including project finance, object
finance, commodities finance, income producing real estate and high volatility commercial real estate.
The major class retail is composed of three subclasses: secured by residential property, qualifying
formula applies. Each bank, based on its own internal ratings system, subdivides each
major asset class by borrower credit grades of relatively homogenous characteristics.
Banks may not select credit grades simply to minimize regulatory capital. They must
demonstrate to regulators that the credit grades provide appropriate predictive powers
and that the bank implements its credit grades for such internal functions as loan
pricing and monitoring in addition to simply meeting regulatory requirements.5 For
each credit grade, the bank provides key variables to plug into the IRB formula. We
simplify the IRB formula as follows:
K IRB LGD K V PD MATA
[1]
KIRB
LGD
KV
revolving and all other retail. In addition, the major classes retail and corporate may contain
eligible purchased receivables.
5
See [1] clause 444. Basel II requires a minimum of seven borrower grades for non-defaulting
corporate, sovereign and bank borrowers and an unspecified number for retail borrowers in order to
provide a meaningful distribution. See [1] clauses 404 and 409.
3.
Oldrich Vasicek, co-founder with Stephen Kealhofer and John Andrew McQuown of
KMV Corporation, a leading commercial developer of standards and procedures for
measuring and pricing bank credit risk6, the Vasicek formula, also called the
asymptotic single risk factor approach [11] is
N 1 PD V N 1 q
KV N
1 V
[2]
Where:
N
N-1
= the level of confidence with which one wishes to establish that the
The formula has not achieved the exposure it deserves partly because it was developed for
commercial purposes. The abstract states This is a highly confidential document that contains
information that is the property of KMV Corporation. This document is being provided to you under
the confidentiality agreement that exists between your company and KMV. This document should only
be shared on a need to know basis with other employees of your business. [14]
7
Probability of survival in each year is 0.999. Observations are independent. 0.999693 = 0.4999, so
693 years elapse before the probability that the bank survives in all years first drops below 50%.
The Vasicek formula assumes that firm asset returns are normally distributed;
however, economic variables seldom exhibit normality. The Vasicek formula is a
single factor model: portfolio risk springs only from a single, economy-wide risk
factor. One might proxy such a single factor by real GDP growth. Yet if we examine
from mid-year 1921 through mid-year 2003 real US GDP growth for example (see
figure 1), we reject the normality assumption8.
[Insert figure 1 here]
Observation 2: Requiring a capital cushion that uses a q=.999 would be far
in excess of most regulators actual requirements if the Vasicek formulas
statistical assumptions approximated reality. A high q is required because the
assumption of normality in the model is flawed.
In the formula, the credit risk of each borrower is expressed as an annual PD.
Each borrower in a credit grade of a class is assumed to be initially identical, with
assets whose values change through time as they are buffeted continuously by shocks
(uncorrelated through time but correlated across borrowers) drawn from a stable,
normal distribution. If the value of assets of a borrower falls below the borrowers
debt, default occurs. Thus PD captures the leverage of the borrowers.
The Basel Committee refers to the Vasicek formula as a so-called Mertonstyle model 9 following Merton [15], who shows that the value of the equity of a
firm equals the value of an in-the-money Black-Scholes model option to purchase the
assets of the firm for the face value of the firms debt. Like Mertons formula, the
Vasicek formula models the assets of borrowing firms as random walks in continuous
time. Bankruptcy occurs when, at option expiry, the value of the assets of the
borrower is less than the face value of the debt of the borrower. But Merton is
8
The real GDP growth series is left skewed (-.94) and fat-tailed (kirtosis = 5.64). The Jarque-Bera
statistic is 37 leading to rejection of normality at the 0.000000 level of confidence.
9
See [7] clause 172.
10
bad state of the economy, where we are 99.9% certain that such a bad state of the
economy will not occur.
Below, we solve for the probability that any given borrower will go bankrupt
in the bad economic state. This is the solution of the conditional probability of default
of a single borrower. Because all borrowers are the same, this conditional probability
is identical to the expected proportion of defaults in the portfolio, conditional on the
poor state of the economy. We then demonstrate that this expected proportion in the
poor state of the economy can be interpreted as the proportion of portfolio at risk in a
value at risk (VAR) sense.
The Conditional Probability of Default of a Single Borrower. We consider
a one-period model. Borrower assets are viewed at t = 0 and again, one year later10.
Let y be the random element in the percent change in value of assets for a single
borrower over a one year horizon. This change is made up of two parts
e and ,
V e 1 V
In equation [3],
[3]
10
The Merton model uses continuous time asset value change. For a demonstration that the continuous
time model reaches the same conclusion as the simple, one period model presented here, contact the
authors.
11
which a borrower becomes insolvent and defaults. We can determine the value of
if we know the value PD by taking the inverse normal of the probability of default
N 1 ( PD) to obtain the critical value of default. For example, if the borrower
[4]
V u
P ( y | e u ) P
1 V
Substituting for
[5]
P( y | e u ) N
1 V
[6]
The reader will note that equation [6] differs only slightly from [2] which we restate
below:
12
N 1 PD V N 1 q
KV N
1 V
[2 (restated)]
13
F ( K v ) N
1 V N 1 K V N 1 p
[7]
We plot this CDF for the unconditional PD of two percent (PD = 2%) and six
values of V from 0.1 percent to 30 percent in figure 3. It shows that an 8 percent
capital ratio would only provide adequate capital, where adequate is defined as
being sufficient 99.9 percent of the time, if the asset correlation is 5 percent or less.
[Insert figure 3 here]
One can interpret the schedules in figure 3 as the VARs of the loan portfolio
(given on the x-axis) associated with a level of confidence given by the CDF function
11
See Gordy [10] and Wilde [17] for conditions under which assumptions of identical PD and exposure
amount can be dropped.
14
on the y-axis.
5.
model: borrowers assets change in value through the impact of only two types of risk,
borrower-specific idiosyncratic risks and a single economy-wide systematic risk. The
model derivation shows that, because of portfolio diversification in bank assets, only
the economy-wide systematic factor requires bank capital to protect the bank against
borrower risk.
The Capital Asset Pricing Model (CAPM) is also a single factor model, but
CAPM is used to calculate the expected returns of equity securities as a function of
risk, not to determine the VAR of a debt portfolio [18]. Like the Vasicek formula,
CAPM demonstrates that, because of portfolio diversification, only one component of
risk counts: economy-wide systematic risk, which CAPM measures with beta.
Unfortunately, empirical tests of realized stock returns show that the market prices
multiple risks: a single factor model such as CAPM performs poorly in explaining
observed stock returns [19]. If a single-factor fails to explain asset returns in the
relatively efficient public equity markets, it is not likely to be more appropriate in
private debt markets.
Commercial credit risk models typically do not make the single factor
assumption. CreditMetrics uses credit rating migration probabilities of each obligors
cash flows and tables of joint probability of migration [20]. Creditrisk+ uses a (small)
number of sectors with a single risk factor in each sector [21]. Moodys-KMV in its
Portfolio ManagerTM software has about 110 factors that the user can specify in
determining obligor returns [11]. Few bankers would suggest that the only risk in
15
their loan portfolios arose from a single, undiversifiable, residual, leveraged, global
factor. Given this lack of theoretical and industry support, it is noteworthy that Basel
II received virtually no criticism of the single factor assumption. The paradox is
resolved by the need for portfolio-indifference. Neither regulators nor bankers would
accept a model that charged different banks different regulatory capital requirements
for the same loan. Yet, without the single factor assumption, an asset in one portfolio
would require (in terms of VAR) a different amount of capital from the same asset in a
different portfolio because the covariances of the asset with the two portfolios would
tend to differ. The only theoretically consistent basis for requiring that every bank
portfolio hold the same percent of risk capital for a given asset is a one-factor risk
model where all portfolios are assumed to be perfectly diversified with respect to all
but that one (undiversifiable) risk.
Observation 3: The theoretical justification for the single factor model is
weak and does not correspond to best practice in the banking industry. It
represents a compromise that allows identical capital charges for identical
risk positions in diverse banks to be theoretically justified.
Granularity. Lack of diversification historically has been one of the main
causes of bank distress, yet IRB assumes that banks have infinitely fine-grained
portfolios. Not only is this unlikely to be true in practice: it is not even desirable as a
bank objective.
16
ri i i rm i
[8]
i
i
m
i ( i )
[9]
where i , m , ( i ) are the standard variance of i-th asset, the return rate of market
portfolio and the random error, respectively.
If y
ri i i E (rm )
rm E (rm )
i
,e
,
, then the variables y, e, are
i
m
( i )
normalized random variables and their variances satisfy the following equation
1 ( i
m 2 ( i ) 2
) (
)
i
i
Letting V ( i
y
[10]
m 2
) , we obtain equation [3] from the equations [9] and [10].
i
V e 1 V
In linear regression, i
[3 (restated)]
im
im
and i
; therefore, the term usually referred to
2
m i
m
[11]
In other words, the correlation between the separate borrows returns is the square of
the correlation between each of the borrowers returns and the single, common,
systematic risk factor.
18
If one accepts the analogy of the market risk in CAPM with the systematic risk
in the Vasicek formula, one can roughly estimate V using widely available data13:
m = 20 percent per annum; the average stock volatility is i = 46 percent per
2
v i i m
i
2
0.435 0.189 ; V 19 percent.
[12]
13
[13]
We obtain data from Damodarans website [24]. We use the standard deviation of equity market
returns from 1928 through 2002 from the spreadsheet Annual Returns on Stock, T.Bonds and T.Bills:
1928 Current and the average asset volatilities of from his spreadsheet Firm Value and Equity
Standard Deviations (for use in real option pricing models) market.
14
Some related models specify the risk process as correlation with the common risk factor where asset
returns are y e 1 2 . See [25,26,27].
19
where SME is the small and medium sized borrower adjustment, applicable only to
firms with less than euros 50 million15. The SME adjustment is:
S 5
SME 0.04 1
45
[14]
where S is the size of the borrower measured by annual sales in millions of euros. In
equation [13] increases in PD lead to decreases in V . Figure 4 shows that, for PD
ranging from 0.01 percent to 7.00 percent, the weight on the lower value correlation
lower ranges between 0.5 percent and 97 percent.
15
1 e 50 PD
50
1 e
V lower
1 e 50 PD
upper
1 e 50
20
-50
SME but as Credit Suisse points out, e is
6. Adjustments in IRB Formula for Loss Given Default, Expected Loss and
Maturity
Loss Given Default. One of the innovations of Basel II is its explicit
recognition of different levels of LGD in different portfolios. Banks under advanced
IRB calculate their own LGDs and input them into equation [1]. The product of [Kv
PD] and LGD determines the percent of capital required. Calculating KV, PD and
LGD separately, however, implies that PD and LGD are independent. Yet experience
teaches that the value of collateral on a loan is inversely related to the probability of
default on the loan. This inverse relationship is borne out both theoretically and
empirically [26,27,29,30].
Observation 7: The assumption that LGD and PD are uncorrelated is made
to simplify the IRB model, and has neither theoretical nor empirical support.
Use of the assumption is likely to result in underestimation of required capital.
The Pro-cyclicality of Loss Given Default and Probability of Default. Procyclicality in setting capital requirements is the tendency for capital requirements to
increase during long recessions and decrease during long booms. In IRB, there are
two sources of pro-cyclicality. First, Basel II prescribes that estimates of PD, LGD
and EAD be obtained from five year horizons yet five years is less than a full
economic cycle. Second, pro-cyclicality may result from periodic credit reviews, if
21
22
charges two percent over the cost of funds and two percent of the portfolio defaults,
then the bank just breaks even (assuming LGD = 1). IRBs treatment of capital for
expected losses is consistent with the statistical interpretation of expected losses being
covered by expected spread income16.
Banks also maintain general loan loss reserves which commonly deviate from
the statistical expectation of loan losses (EL):
EL = PD x LGD x EAD
[15]
A bank may use loan loss reserves as a quasi-equity cushion, a means of reducing
taxes, a smoothing device for income or a provision for portfolios whose losses may
exceed the spread income described above. The use of loan loss reserves, moreover,
can differ considerably from bank to bank, country to country and time to time.
General loan loss reserves have traditionally been a part of Tier II capital (up
to a ceiling of 1.25 percent); however, under Basel II, IRB banks are not allowed this
use of general loan loss reserves. Instead they calculate EL as given above and, if
general loan loss reserves are less than EL, they must subtract the difference from
capital. If general loan loss reserves are more than EL, IRB banks can use the
difference as part of Tier II capital to the extent that it does not exceed 0.6 percent of
credit risk weighted assets 17. The calculations of EL and its netting from loan loss
reserves are made without reference to expected spread income.
Observation 9: The requirement that loan loss reserves be aligned with EL
institutionalizes a double counting, whereby EL are covered as a matter of
pricing by the spread over the cost of funds as well as by loan loss reserves
which under IRB must be no less than EL. This may penalize high EL lending
(such as retail and credit card lending).
16
In the initial drafts of Basel II only 75 percent of PD in only one class of loans, revolving retail loans,
was added back in what was called the future margin income adjustment [5,6].
17
See [1] clauses 43, 375, 380-383 and 386.
23
Maturity. The final adjustment in the IRB formula is the adjustment for the
average maturity, MATA in equation [1] above. That adjustments is given as
MATA
1 ( m 2.5)b( PD)
1 1.5b( PD )
[16]
where b(PD) =
maturity
adjustment
function
tP
m
P
Pt
The Vasicek formula calculates capital for a one-year horizon. Since a longer
maturity loan to a borrower merits a higher capital charge than a shorter maturity loan
to the same borrower, IRB adjusts Vasicek for maturity. The adjustment accounts for
the potential for credit deterioration being larger for higher rated credits than for lower
rated credits that have a potential not only for deterioration but also for improvement.
Figure 5 shows how equation [14] adjusts for four different PDs.
In the consultation rounds of Basel II, the MATA adjustment incurred only one
consistent criticism from bankers: adjustments for very short-term facilities are
insufficient. Using the 0.5 percent probability of default, for example, MATA would
allow a risk adjustment of only 0.78 of for a loan with zero maturity when, in the view
of most bankers, such a facility would be essentially risk-less [32].
Observation 10: The adjustment for maturity is in accord with industry
practice; however, it allows insufficient reduction of required capital for very
short term facilities.
24
6.
Conclusion
The IRB is a hybrid between a very simple statistical model of capital needs
for credit risk and a negotiated settlement. The statistical model used is not best
practice today and certainly will not become so in the future. Given the constraints
of the regulatory environment and the rapid development of risk management,
however, regulators would be unable impose a uniform best practice solution onto
all banks. Our observations reinforce the Basel Committees view that the IRB is
work-in-progress and will remain so long after the implementation of Basel II18.
18
25
References
[1] Basel Committee on Banking Supervision. International convergence of capital
measurement and capital standards: a revised framework. Basel; June 2004.
[2] Jorion, P. Value at risk. McGraw Hill, New York; 2001.
[3] Basel Committee on Banking Supervision. International convergence of
capital measurement and capital standards. Basel Committee Publications No. 4, Bank
for International Settlements, Basel; July 1988.
[4] Basel Committee on Banking Supervision. A new capital adequacy framework.
Basel Committee Publications No. 50, Basel; June 1999.
[5] Basel Committee on Banking Supervision. The new Basel capital accord:
Consultative document issued for comment by 31 May 2001. Basel; January 2001.
[6] Basel Committee on Banking Supervision. The new Basel capital accord:
Consultative document issued for comment by 31 July 2003. Basel; April 2003.
[7] Basel Committee on Banking Supervision. The internal ratings based approach:
Consultative document: supporting document to the new Basel capital accord issued
for comment by 31 May 2001. Basel; January 2001.
[8] Basel Committee on Banking Supervision. Potential Modifications to the
Committees Proposals. Press release. Basel; 5 November 2001.
[9] Gordy, M.A comparative anatomy of credit risk models. Journal of Banking and
Finance 2000; 24 (1-2): 119-49.
[10] Gordy, M. A risk factor model foundation for ratings based capital rules. Board
of Governors of the Federal Reserve System working paper 2002.
[11] Lopez, JA. The empirical relationship between average asset correlation , firm
probability of default and asset size. Economic Research Department, Federal Reserve
Bank of San Francisco 2002.
[12] Wilde, T. IRB approach explained. Risk. May 2001: 87-90.
[13] British Bankers Association and the London Investment Banking Association.
Response to the Basel Committees Second Consultation on a new Basel Accord. May
2001. Available from http://www.bis.org/bcbs/ca/bribanass.pdf.
[14] Vasicek, O. Probability of loss on loan portfolio. KMV Corporation. 1987
Available from www.moodyskmv.com/research/portfoliotheory.html.
[15] Merton, RC. On the pricing of corporate debt: The risk structure of interest rates.
The Journal of Finance 1974; 29(2): 449-70.
[16] Vasicek, O. Limiting loan loss probability distribution. KMV Corporation 1991
26
27
Figure 1
Frequency of US Annual Real Growth Rates
14
12
frequency
10
28
0.45
0.4
0.35
0.3
Good states
Bad states
0.25
0.2
0.15
0.1
0.05
Normalized economic
growth rate exceeded with
99.9% probability e = u = -3.09
29
Normalized average
Growth rate e = 0
4.9
4.7
4.4
4.2
4.0
3.7
3.5
3.3
3.0
2.8
2.6
2.4
2.1
1.9
1.7
1.4
1.2
1.0
0.7
0.5
0.3
0.1
-0.2
-0.4
-0.6
-0.9
-1.1
-1.3
-1.6
-1.8
-2.0
-2.2
-2.5
-2.7
-2.9
-3.2
-3.4
-3.6
-3.9
-4.1
-4.3
-4.5
-4.8
-5.0
Figure 3
30
31
Probability of Default
0.068
0.066
0.064
0.062
0.060
0.057
0.055
0.053
0.051
0.049
0.046
0.044
0.042
0.040
0.038
0.035
0.033
0.031
0.029
0.026
0.024
0.022
0.020
0.018
0.016
0.013
0.011
0.009
0.007
0.005
0.002
0.000
Figure 4
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
Table 1
Correlations and maturity adjustments
Exposure
lower
upper
Sovereign,
corporate
and bank
SMEs
0.12
0.24
0.12 minus
0.0 to 0.04
0.12
0.24 minus
0.0 to 0.04
0.30
Yes
0.15
No
0.04
No
0.16
--
Highly
Volatile
Commercial
Real Estate
Residential 0.15
Mortgage
Revolving
0.04
Retail (eg.,
credit
cards)
Other Retail 0.03
Exposures
Y: maturity
adjust
ment
Yes
Yes
32
Figure 5
33