Regulatory Treatment of the Double Default Effect under the New Basel Accord: How conservative is it
by Peter Grundke of the University of Cologne
Abstract: Within the internal ratings-based approach of the New Basel Accord, banks have the possibility to consider the so-called double default effect of guaranteed exposures. However, the correlation assumptions inherent in the regulatory recognition of the double default effect appear to be quite conservative. To evaluate the degree of conservatism, on one hand, the regulatory correlation assumptions are compared with the results of a broad range of empirical studies. On the other hand, additional simulation experiments are carried out. While the comparison with the empirical results indeed suggests that the correlation parameters assumed by the regulatory authorities are much too large, the simulation experiments show that the assumed values are not unrealistic for capturing the intended effects.
Keywords: Asset return correlation, Concentration risk, Double default effect, New Basel Accord, Wrong-way-risk.
Published in: Review of Managerial Science, Vol. 2, No. 1. (March 2008), pp. 37-59.