COMMERCIAL AND INDUSTRIAL MATHEMATICS

PRMIA Risk Management Seminar March 17, 2004 5:00 p.m. Erik A. Heitfield Monetary and Financial Studies, Division of Research and Statistics, Federal Reserve Board

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Rating System Dynamics and Bank-Reported Default Probabilities under the New Basel Capital Accord

This paper uses a stylized model of credit rating systems to examine the interaction between a bank's rating philosophy and the default probabilities (PDs) it will be required to report under new regulatory capital standards being developed by the Basel Committee on Banking Supervision (Basel II). I show that the process of assigning obligors to risk buckets and then estimating long-run average pooled PDs for each risk bucket prescribed by the Basel Committee does not draw a direct link between the actual likelihood of default associated with an individual obligor and the pooled PD associated with the grade to which the obligor is assigned. As a result, the dynamic properties of the PDs assigned to obligors under Basel II depend on a bank's rating philosophy.

This finding has implications for the cyclicality of regulatory capital requirements. Capital requirements for banks that adopt point-in-time rating systems can be expected to be more counter-cyclical than those for banks that adopt through-the-cycle rating systems. It also has implications for the supervisory validation of the pooled PDs that banks report. Accurately benchmarking pooled PDs across banks will require that supervisors account for differences in rating philosophies. Backtesting pooled PDs against observed default frequencies will be most effective when banks adopt point-in-time rating systems.

A PDF copy of the paper is available here.

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ERIK A. HEITFIELD
Research and Statistics Division
Board of Governors of the Federal Reserve System

Since receiving his Ph.D. in economics from the University of California, Berkeley in 1998, Erik Heitfield has worked for the Board of Governors of the Federal Reserve System. As a staff economist in the Board's Monetary and Financial Studies section, Dr. Heitfield conducts research and technical analysis in support of the Board's bank supervision and regulation responsibilities. Dr. Heitfield is actively involved in ongoing work to develop the New Basel Capital Accord (Basel II). His most recent research focuses on the measurement and management of credit risk in complex banking organizations.

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