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Capital Allocation for Portfolio Credit Risk

by Paul H. Kupiec of the Federal Deposit Insurance Corporation

August 2006

Abstract: Capital allocation rules are derived that maximize leverage while maintaining a target solvency rate for credit portfolios where risk is driven by a single common factor and idiosyncratic risk is fully diversified. Equilibrium conditions ensure that capital allocations depend on interest earnings as well as credits' probability of default, endogenous loss given default, and asset correlation. Capitalization rates exceed those estimated using Gaussian credit loss models. Results demonstrate that credit risk is undercapitalized by the Basel II AIRB approach in part because of ambiguities regarding the definition of loss given default. An alternative proposed capital rule removes this bias.

JEL Classification: G12, G20, G21, G28.

Keywords: economic capital, credit risk internal models, Basel II Internal Ratings Approach.

Published in: Journal of Financial Services Research, Vol. 32, No. 1-2, (October 2007), pp. 103-122.

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