Basel II: Correlation Related Issues

Basel II aims to aggressively improve on Basel I, and is projected to capitalize on the technological advancements that have permeated the financial industry since Basel I. This paper examines the correlation issues that arise, and provides recommendations on implementation as we move forward. We provide the following results: (1) We demonstrate that fixing asset value correlations by regulators without a specification of business unit granularity and aggregation impacts franchise risk. (2) Loss distributions for credit risk are more sensitive to correlation assumptions that those for market risk; arbitrary, inaccurate correlation specifications can cause large errors in capital requirements. (3) Current regulations do not recognize that credit losses depend on four distinct correlations, not just one. (4) Recovery rates may be determined uniformly across banks. (5) Tail risk comes from LGD correlations and non-Gaussian risks. (6) The 1-year VaR horizon causes distortions especially when regimes and pro-cyclicality are involved. (7) We recommend a quantitative measure for implementing market discipline, the third pillar of the Basel II accord. Therefore, this paper highlights many issues that may be addressed using the tools banks already employ for internal risk management.

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