Benchmarking of Credit Risk Models For Determining Own Funds Requirements

Paolo Bisio, Samuel Da-Rocha-Lopes and Aurore Schilte

In comparison with the previous framework, it is undisputable that the implementation of Basel II and the introduction of internal models promoted the adoption of stronger risk management practices by the banking industry as one of its major benefits. To recall, the previous framework raised several important questions, whether fixed and standardised – ie, non-risk-sensitive capital requirements had been successful in limiting risk-taking relative to capital as intended. Most of the questions were linked to the fact that banks were able to take actions to reduce capital requirements effectiveness. Among several actions to reduce capital requirements, it was the banks’ capacity to use capital arbitrage or to shift to riskier assets within the same weighting band that were key.

The Basel II and the introduction of the internal ratings based (IRB) approach to capital requirements for credit risk allows for greater risk sensitivity. A capital requirement based on internal ratings proved to be more sensitive to the drivers of credit risk and economic loss in a bank’s portfolio, not allowing possible shifts to riskier assets within the same weighting band and permitting the reduction