A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules

Posted: 7 Dec 2004

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Abstract

I demonstrate that ratings-based capital rules, including both the current Basel Accord and its proposed revision, can be reconciled with the general class of credit value-at-risk models. Each exposure's contribution to VaR is portfolio-invariant only if (a) dependence across exposures is driven by a single systematic risk factor, and (b) no exposure accounts for more than an arbitrarily small share of total portfolio exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

JEL Classification: G31, G38

Suggested Citation

Gordy, Michael B., A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules. Journal of Financial Intermediation, Vol. 12, 2003. Available at SSRN: https://ssrn.com/abstract=627429

Michael B. Gordy (Contact Author)

Federal Reserve Board ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3705 (Phone)

HOME PAGE: http://https://www.federalreserve.gov/econres/michael-b-gordy.htm

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