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| A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules by Michael B. Gordy of the Federal Reserve Board October 22, 2002 Abstract: When economic capital is calculated using a portfolio model of credit value-at-risk, the marginal capital requirement for an instrument depends, in general, on the properties of the portfolio in which it is held. By contrast, ratings-based capital rules, including both the current Basel Accord and its proposed revision, assign a capital charge to an instrument based only on its own characteristics. I demonstrate that ratings-based capital rules can be reconciled with the general class of credit VaR models. Contributions to VaR are portfolio-invariant only if (a) there is only a single systematic risk factor driving correlations across obligors, and (b) no exposure in a portfolio accounts for more than an arbitrarily small share of total 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. Published in: Journal of Financial Intermediation, Vol. 12, No. 3, (July 2003), pp. 199-232. Books Referenced in this Paper: (what is this?)
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