Basel-II News

Fitch Ratings: Evaluating Basel II Asset Correlations Empirically

(May 20, 2008)-- A new report by Fitch demystifies the Basel II treatment of asset correlation and provides original empirical analysis of the correlation values assumed under the internal-ratings based (IRB) approach across a range of asset classes.

"Asset correlation is an influential parameter affecting both absolute and relative IRB capital requirements across financial institutions. Empirically analyzing the regulatory correlation assumptions is therefore an important dimension of interpreting and evaluating Basel II risk-based capital ratios," said Krishnan Ramadurai, Managing Director, Fitch Financial Institutions group.

In performing this research, Fitch analyzed historical loss rate data for credit card, consumer, residential mortgage, commercial mortgage, and corporate lending to derive empirically-based estimates of asset correlation for each asset class based on the IRB formulas and concepts.

"Statistical analysis of the mean and standard deviation of historical loss rates enables the generation of a credit loss distribution consistent with the IRB approach. From this distribution, we then compute capital levels at the 99.9th percentile loss corresponding to the Basel II calibration and, in turn, derive the value of the asset correlation parameter that produces this level of capital under the IRB formulas," said Gary van Vuuren, Senior Director, Fitch Financial Institutions group.

An important finding of this study is that the regulatory-specified Basel II correlation assumptions are generally higher than asset correlations derived empirically from historical data. This result is not unexpected given the global scope of Basel II and the need to address, for example, differences in portfolio composition and risk concentrations across banks within a single regulatory framework.

"While at first glance the Basel II correlation assumptions appear to be somewhat conservative, it is important to bear in mind that, during periods of financial market stress, realized correlation values tend to rise relative to historical experience. Additionally, Basel II applies static correlation values to reflect the behavior of assets whose risk profile and portfolio volatility could potentially increase in the future, for example due to the emergence of new risk factors affecting performance or to structural changes within financial markets," said Martin Hansen, Senior Director, Fitch Credit Market Research.

The study's findings support Fitch's view that stress testing, particularly the analysis of scenarios capturing higher correlation patterns, is important to assessing the rigor and risk-sensitivity of a financial institution's Basel II capital ratios.

Other findings of note from the Fitch research study are:

--Basel II correlation assumptions are broadly consistent with the empirically-derived correlations on an ordinal or relative basis across asset classes;

--Contrary to widely-held views, there does not appear to be a uniform statistical relationship between asset correlations and default probabilities; and

--Empirically-derived correlations vary geographically.

The Basel II capital framework, currently being implemented widely across the global banking sector, is a significant regulation that Fitch believes will promote stronger risk management practices and more informative measures of risk-based capital within the banking industry.

The IRB approach to measuring regulatory capital for credit risk is a cornerstone of Basel II. The IRB approach generates risk-based capital charges on an asset through a formula that harnesses estimates of an obligor's probability of default (PD), loss given default (LGD), and correlation of the obligor's asset value to an undefined systematic risk factor, which can be thought of as general economic conditions. PD and LGD parameters are estimated by IRB banks based on internal risk assessments, while the level of the asset correlation parameter is predetermined and set within the regulation at specific values that differ by asset class.

The report 'Basel II Correlation Values: An Empirical Analysis of EL, UL, and the IRB Model' is available on the Fitch Ratings web site at www.fitchratings.com. The web site requires users to perform a simple log on process. The report can be found by linking to 'Credit Market Research' (under 'Market Focus') and then clicking on 'Research'.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Share or bookmarklet this web page at: