The Criticism of Basel II Based on Credit Risk Modelling

Abstract

The aim of the paper is to critically evaluate the regulatory principles of Basel II, based on credit risk modelling. The paper is based on the definition of credit risk, default and necessary literature research dealing with the topic. The Internal Rating-Based (IRB) approach for calculating the capital requirement to cover losses from credit risk is evaluated. Within this calculation it deals with the right choice of parameters of probability of default and loss given default for the calculation of risk-weighted assets and following setting of the capital requirement to cover credit risk. The definition of default was, in the calculation based on the model data, gradually tightening so that even claims whose loss given default equal to 0 % was identified as the default. It is evident from the calculations that the bank can control (to some degree), by using an appropriate choice of the definition of default, the amount of risk weight and the subsequent amount of capital requirement. The paper further analyses the key role of correlation in credit risk modelling. The calculations indicate in this case that the value of correlation may significantly affect the amount of capital required to cover the risk, i.e. the capital requirement. The IRB approach may not be the right measure for the allocation of capital in banks, because IRB outputs cannot be considered as an estimate of the actual economic capital. Finally the paper points to the pro-cyclical character of Basel II, because the risk parameters fluctuate in time with the economic cycle, as well as the actual capital requirements for credit risk.