Procyclicality of capital and portfolio segmentation in the advanced internal ratings-based framework: an application to mortgage portfolios

Abstract

This paper investigates the procyclicality of capital in the advanced internal ratings-based (A-IRB) Basel approach for retail portfolios, and identifies the fundamental assumptions required for stable A-IRB risk weights over the economic cycle. Specifically, it distinguishes between cyclical and acyclical segmentation risk drivers and, through application to a portfolio of first mortgages, shows that risk weights remain stable over the economic cycle when the segmentation scheme is derived using acyclical risk drivers, while segmentation schemes that include cyclical risk drivers are highly procyclical. This paper also analyzes the sensitivity of the A-IRB framework to model risk resulting from the selection, at the quantification stage, of a data sample period that does not include a period of significant economic downturn. The analysis illustrates important limitations and sensitivities of the A-IRB framework and sheds light on the implicit restrictions embedded in recent regulatory guidance that underscore the importance of rating systems that remain stable over time and throughout business cycles.