The Use of Internal Models: Comparison of the New Basel Credit Proposals with Available Internal Models for Credit Risk

Michel Crouhy, Dan Galai and Robert Mark

in Capital Adequacy beyond Basel

Published in print March 2005 | ISBN: 9780195169713
Published online January 2007 | e-ISBN: 9780199783717 | DOI:
 The Use of Internal Models: Comparison of the New Basel Credit Proposals with Available Internal Models for Credit Risk

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This chapter presents the New Capital Adequacy Accord proposed by the Basel Committee on Banking Supervision (Basel II) to replace the current 1988 Capital Accord (Basel I) by a more risk-sensitive framework for the measurement of credit risk. Basel II offers a menu of approaches: the “standardized” approach and the “internal ratings based” (IRB) approach with two variants: the “foundation” and the “advanced” approaches. These approaches are reviewed and their shortcomings are discussed. The standardized approach presents similar flaws to Basel I. The regulatory capital attribution according to the IRB approach is compared with the economic capital allocation from the industry-sponsored credit portfolio models, including CreditMetrics, KMV, and CreditRisk+. This comparison shows that the capital attribution for investment grade facilities from the IRB approach, although much lower than for the standardized approach, is still too high compared with the allocation from internal models. For subinvestment grade portfolios, the opposite is true where the IRB approach allocates more capital than the standardized approach, but still much less than the internal models. It is also noted that when the various credit portfolio models are calibrated with consistent parameters, they produce capital attributions that are relatively close to one another. It is clear from these conclusions that regulatory arbitrage will prevail as banks will be incentivized, as under Basel I, to shed away their high-quality assets through loan sales and securitization, and keep on their balance sheet the more risky loans for which regulatory capital underestimates the actual economic risk.

Keywords: New Capital Adequacy Accord; risk management; internal ratings; capital regulation; capital allocation

Chapter.  23834 words.  Illustrated.

Subjects: Financial Markets

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