The Asymptotic Single Risk Factor Model

As already mentioned in Section 2.1, the Basel Committee on Banking Supervision released a Revised Framework, also called Basel II, in June 2004. The supervisory rules are intended to provide guidelines for the supervisory authorities of the individual nations such that they can implement them in a suitable way for their banking system. Basel II provides details for adopting more risk sensitive minimal capital requirements, so-called regulatory capital (Pillar 1). Moreover it lays out principles for the supervisory review process of capital adequacy (Pillar 2) and seeks to establish market discipline by enhancing transparency in banks’ financial reporting (Pillar 3 ). The Revised Framework incorporates new developments in credit risk management as it is more flexible and risk sensitive than the former Basel I accord. Moreover, within Basel II banks may opt for the standard approach, which is quite conservative with respect to capital charge, and the more advanced, so-called Internal Ratings Based (IRB) approach when calculating regulatory capital for credit risk. Financial institutions that opt for the IRB approach are allowed to use their own internal credit risk measures as inputs to the capital calculation whenever these are approved by the supervisory authorities. Therefore banks have to prove that certain conditions concerning the method and transparency are fulfilled. In the IRB approach banks are allowed to determine the borrower’s default probabilities using their own methods while those using the advanced IRB approach are further permitted to provide own estimates of LGD and EAD. The Basel II risk weight formulas then translate these risk measures into risk weights and regulatory capital requirements which are intended to ensure that unexpected losses can be covered up to a certain confidence level, prescribed by the supervisors.