Model-Based Approaches to Risk Weighting

Abstract This chapter discusses the Basel risk model. Every financial institution expects to suffer some level of default. Consequently, all properly run banks make provisions for some level of default on their existing assets. This is known as expected loss. At some points losses will be lower than those expected, and at some points they will be higher. The task of the regulator is to set a capital requirement which just skims the top of the actual loss experience curve. If the capital requirement is set significantly higher than this, then banks will be penalized by being required to hold excessive capital, if it is set lower, then the risk of bank failure increases. The remainder of the chapter covers Value at Risk and the Basel framework; the basic Basel formula; specific amendments for different classes; translating between capital requirements and risk weightings; illustrative risk weights; and variations in credit risk weightings between firms.