eThesis - School of Business electronic theses

Basel II rules put forward by Basel Committee on Banking Supervision introduced a more risk-sensitive approach to banks to calculate regulatory capital requirements. This more risk-sensitive framework includes an option for banks to apply for permission to use Internal-ratings based approach in which the bank can estimate some parameters by itself without resulting to supervisory estimates. The framework for calculating the capital requirement for exposures in corporate portfolio includes a correlation function in which the bank's own estimate of probability of default would be the only variable.

However, the correlation function used in Basel's internal ratings-based approach is not based on a strong theoretical foundation but instead relies on few simple assumptions according to which the function was formed and the calibration was done and later revised. The paper aims to analyze some of the limitations the function induces to the framework by first going through the existing critique in the literature and then calculating asset correlations implied by loss distributions of different industries and sectors and drawing from sensitivity analysis of risk-weighted assets and loan margin.

The resulting asset value correlations calculated from the empirical dataset in this paper are close to what previous studies on default data have found to be the empirical level. The dataset is based on the ratio of gross impairment to loans and guarantees. Furthermore the feasibility of the results is assessed through three hypotheses which all assist in showing the feasibility of the chosen approach. The results show that asset value correlations and both expected and unexpected losses are different among industries.