Assessing Validity and Accuracy of the Basel II Model in Measuring Credit Risks of Individual Borrowers and Credit Portfolios

The paper assesses the validity and accuracy of measuring risks of individual borrowers and credit portfolios by means of the Basel II credit risk model. The assessment method consists in parallel estimation of the same risks by means of exact probabilistic models. We find that the Basel II model gives a correct estimate of the possible credit losses for medium and large portfolios of thirty or more one-period credits (credits without intermediate payments - interest etc.). For small portfolios and individual one-period credits the estimates of the Basel II model are inaccurate or very inaccurate. The model undervalues the credit risk of portfolios of multi-period credits (credits with active period covering several years and intermediate payments). This study presents an alternative view on some of the major Basel II concepts, such as correlation and probability of default (PD). This can lead to a better understanding and more flexible use of those concepts in assessing credit risks.The exact models are more complicated than the Base ll model, but quite suitable for rapid computer calculations. They can be used in bank practice, providing flexible assessments of credit risk