Financial Stability and Basel Ii

Abstract

The Basel II Advanced Internal Ratings (AIRB) approach is compared to capital requirements set using an equilibrium structural credit risk model. Analysis shows the AIRB approach undercapitalizes credit risk relative to regulatory targets and allows wide variation in capital requirements for a given exposure owing to ambiguity in the definitions of loss given default and exposure at default. In contrast, the Foundation Internal Ratings Based (FIRB) approach may over-capitalize credit risk relative to supervisory objectives. It is unclear how Basel II will buttress financial sector stability as it specifies the weakest risk regulatory capital standard for large complex AIRB banks.

Keywords: credit risk measurement, credit risk capital allocation, Basel II

JEL Classification: G12, G20, G21, G28