Chapter 22 - Aligning Regulatory Capital with Economic Capital: An Alternative Approach to Risk Weights According to Basel II

Abstract

This chapter discusses four main shortcomings of the Basel II risk weight determination—namely, the treatment of maturity, dependency of the correlation parameter, lack of diversification, and confidence level aspects. A proposal is made to mitigate each of these weaknesses by the introduction of a simple model that can be easily implemented in any financial institution. Each aspect is illustrated separately with examples and figures. The Basel II calculation of risk weights for credit risk is widely being criticized for being a compromise that takes a leap from the present regulatory capital framework toward internal credit risk models, but stops halfway. The chapter also presents some modifications to mitigate the shortcomings of Basel II. It argues that that providing regulatory bodies with the possibility of adjusting the confidence level within the Basel II risk weight formula can help to stabilize the financial system.