The Empirical Relationship between Average Asset Correlation, Firm Probability of Default and Asset Size

FRB of San Francisco Working Paper No. 2002-05

65 Pages Posted: 4 May 2005

See all articles by Jose A. Lopez

Jose A. Lopez

Federal Reserve Bank of San Francisco

Date Written: June 2002

Abstract

The asymptotic single risk factor (ASRF) approach is a simplified framework for determining regulatory capital charges for credit risk and has become an integral part of how credit risk capital requirements are to be determined under the second Basel Accord. Within this approach, a key regulatory parameter is the average asset correlation. In this paper, we examine the empirical relationship between the average asset correlation, firm probability of default and firm asset size measured by the book value of assets by imposing the ASRF approach within the KMV methodology for determining credit risk capital requirements. Using data from year-end 2000, credit portfolios consisting of U.S., Japanese and European firms are analyzed. The empirical results suggest that average asset correlation is a decreasing function of probability of default and an increasing function of asset size. When compared with the average asset correlations proposed by the Basel Committee on Banking Supervision in November 2001, the empirical average asset correlations further suggest that accounting for firm asset size, especially for larger firms, may be important. In conclusion, the empirical results suggest that a variety of factors may impact average asset correlations within an ASRF framework, and these factors may need to be accounted for in the final calculation of regulatory capital requirements for credit risk.

Keywords: Risk management

Suggested Citation

Lopez, Jose Antonio, The Empirical Relationship between Average Asset Correlation, Firm Probability of Default and Asset Size (June 2002). FRB of San Francisco Working Paper No. 2002-05. Available at SSRN: https://ssrn.com/abstract=713721 or http://dx.doi.org/10.2139/ssrn.713721

Jose Antonio Lopez (Contact Author)

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States
415-977-3894 (Phone)
415-974-2168 (Fax)

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