Industry Practices in Credit Risk Modeling and Internal Capital Allocations: Implications for a Models-Based Regulatory Capital Standard

Bank supervisors have long recognized two types of shortcomingsin the Basle Accord’s risk-based capital (RBC)framework. First, the regulatory measures of “capital” maynot represent a bank’s true capacity to absorb unexpectedlosses. Deficiencies in reported loan loss reserves, forexample, could mask deteriorations in banks’ economic networth. Second, the denominator of the RBC ratios, totalrisk-weighted assets, may not be an accurate measure oftotal risk. The regulatory risk weights do not reflectcertain risks, such as interest rate and operating risks.More importantly, they ignore critical differences in creditrisk among financial instruments (for example, all commercialcredits incur a 100 percent risk weight), as well asdifferences across banks in hedging, portfolio diversification,and the quality of risk management systems.[...]