A Risk-factor Model Foundation for Ratings-based Bank Capital Rules

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Gordy, Michael B., "A Risk-factor Model Foundation for Ratings-based Bank Capital Rules", Journal of Financial Intermediation, Vol. 12, No. 3, (July 2003), pp. 199-232.

Abstract: I demonstrate that ratings-based capital rules, including both the current Basel Accord and its proposed revision, can be reconciled with the general class of credit value-at-risk models. Each exposure's contribution to VaR is portfolio-invariant only if (a) dependence across exposures is driven by a single systematic risk factor, and (b) no exposure accounts for more than an arbitrarily small share of total portfolio exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

JEL Classification: G31, G38.

Keywords: Capital allocation, Banking regulation, Value-at-Risk.

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