by Michael B. Gordya and Eva Lütkebohmertb
The credit value-at-risk model underpinning the internal ratings-based approach of Basel II and III assumes that idiosyncratic risk has been fully diversified in the portfolio, so that economic capital depends only on systematic risk contributions. We propose a simple granularity adjustment (GA) for approximating the effect of undiversified idiosyncratic risk on required capital. To mitigate operational burden in implementation, we derive upper and lower bounds on the GA under incomplete information on the portfolio. We assess the magnitude and accuracy of the proposed GA on a set of bank portfolios drawn from the German credit register.
JEL Codes: G32, G28, G17.
Full article (PDF, 40 pages 629 kb)
a Federal Reserve Board
b University of Freiburg