White Papers for Basel II Capital Accord (Basel II)

Credit Risk versus Capital Requirements under Basel II Are SME Loans and Retail Credit Really Different?

SVERIGES RIKSBANK

The new Basel II regulation contains a number of new regulatory features. Most importantly,
internal ratings will be given a central role in the evaluation of the riskiness of bank loans. Another
novelty is that retail credit and loans to small and medium-sized enterprises will receive a special
treatment in recognition of the fact that the riskiness of such exposure derives to a greater extent from
idiosyncratic risk and much less from common factor risk. Much of the work done on the differences
between the risk properties of retail, SME and corporate credit has been based on parameterized
models of credit risk. In this paper we present new quantitative evidence on the implied credit
loss distributions for two Swedish banks using a non-parametric Monte Carlo re-sampling method
following Carey [1998]. Our results are based on a panel data set containing both loan and internal
rating data from the banks’ complete business loan portfolios over the period 1997-2000. We compute
the credit loss distributions that each rating system implies and compare the required economic capital
implied by these loss distributions with the regulatory capital under Basel II. By exploiting the fact
that a subset of all businesses in the sample is rated by both banks, we can generate loss distributions
for SME, retail and corporate credit portfolios with a constant risk profile. Our findings suggest that
a special treatment for retail credit and SME loans may not be justified. We also investigate if any
alternative definition of SME’s and retail credit would warrant different risk weight functions for these
types of exposure. Our results indicate that it may be difficult to find a simple risk weight function
that can account for the differences in portfolio risk properties between banks and asset types.

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