Assessing the Basel II Internal Ratings-Based Approach: Empirical Evidence from Australia

TL;DR

This paper empirically evaluates Australia's Basel II IRB approach using internal bank data, finding general macroeconomic agreement but questioning the model's validity during diverse economic conditions and the 2007-09 financial crisis.

Contribution

It provides the first empirical assessment of the Basel II IRB model in Australia using internal data, especially during the financial crisis period.

Findings

Model aligns with macroeconomic indicators during stable periods.

Questions validity of IRB model during economic fluctuations.

Highlights impact of 2007-09 crisis on Australian banking sector.

Abstract

The Basel II internal ratings-based (IRB) approach to capital adequacy for credit risk implements an asymptotic single risk factor (ASRF) model. Measurements from the ASRF model of the prevailing state of Australia's economy and the level of capitalisation of its banking sector find general agreement with macroeconomic indicators, financial statistics and external credit ratings. However, given the range of economic conditions, from mild contraction to moderate expansion, experienced in Australia since the implementation of Basel II, we cannot attest to the validity of the model specification of the IRB approach for its intended purpose of solvency assessment. With the implementation of Basel II preceding the time when the effect of the financial crisis of 2007-09 was most acutely felt, our empirical findings offer a fundamental assessment of the impact of the crisis on the Australian banking sector. Access to internal bank data collected by the prudential regulator distinguishes our research from other empirical studies on the IRB approach and recent crisis.