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

Michael B Gordy

Large commercial banks and other financial institutions with significant credit exposure rely increasingly on models to guide credit risk management at the portfolio level. Models allow management to identify concentrations of risk and opportunities for diversification within a disciplined and objective framework, and thus offer a more sophisticated, less arbitrary alternative to traditional lending limit controls. More widespread and intensive use of models is encouraging a more active approach to portfolio management at commercial banks, which has contributed to the improved liquidity of markets for debt instruments and credit derivatives.

Stripped to its essentials, a credit risk model is a function mapping from a parsimonious set of instrument-level characteristics and market-level parameters to a distribution for portfolio credit losses over some chosen horizon. The model output of primary interest, the “economic capital” required to support the portfolio, is derived as some summary statistic of the loss distribution. Once allocated to the individual instruments as capital charges, economic capital provides a shadow price on the cost of holding each position. Directly or

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