The single risk factor approach to capital charges in case of correlated loss given default rates

TL;DR

This paper introduces a novel methodology for integrating LGD correlation effects into Basel II capital calculations using a single loss variable model, with numerical comparisons to existing Basel proposals.

Contribution

It proposes a new single risk factor approach to model LGD correlation effects in capital charge calculations, improving upon current Basel II methods.

Findings

New formulas for capital charges incorporating LGD correlation

Numerical comparison shows differences with Basel Committee proposals

Enhanced understanding of LGD correlation impact on capital requirements

Abstract

A new methodology for incorporating LGD correlation effects into the Basel II risk weight functions is introduced. This methodology is based on modelling of LGD and default event with a single loss variable. The resulting formulas for capital charges are numerically compared to the current proposals by the Basel Committee on Banking Supervision. Keywords: Regulatory capital charge, loss given default (LGD).