An assessment of the internal rating-based approach in Basel II

Simone Varotto

Abstract

ABSTRACT

The new bank capital regulation commonly known as Basel II includes an internal rating-based (IRB) approach to measuring credit risk in bank portfolios. The IRB approach relies on the assumptions that the portfolio is fully diversified and that systematic risk is driven by one common factor. In this work we empirically investigate the impact of these assumptions by comparing the risk measures produced by the IRB approach with those of a more general credit risk model that allows for multiple systematic risk factors and portfolio concentration. Our tests, conducted on a large sample of eurobonds over a 10-year period, reveal that deviations between the IRB approach and the general model can be substantial.