Technische Universität München Credit as an Asset Class - risklab

CHAPTER 2. CREDIT RISK TRANSFER
• Recovery rates – the fraction of the nominal amount which may be recovered in case
of counterparty default.
• Credit migration – the expected changes in credit quality of the obligor or counter-
party.
Furthermore, there are portfolio risk elements:
• Default and credit quality correlation – the degree of correlation between default or
credit quality of one obligor and another.
• Risk contribution and credit concentration – the contribution of one instrument in
the portfolio to the overall portfolio risk. 2
2.1.2 Credit Risk and Regulation
Bearing credit risk is an essential part of banking and a significant source of income
for financial institutions. Consequently, it is important to monitor and manage the risk
positions in the portfolio continuously. In order to have a diversified credit portfolio, it
is crucial to avoid concentration of credit risk vis-à-vis a client or an industry. This is
vital for each single financial institution in order to reduce its risk of financial distress and
thus ensuring the stability of the financial system, which is finally the main reason for
regulation.
1988 Basel Accord
According to the 1988 Basel Accord, banks have to hold capital in reserve – the so-
called regulatory capital – in order to be able to offset losses resulting from credit or
market risk. It uses only four different risk weights to distinguish between asset categories.
Thus, the risk structure of the assets in a bank’s balance sheet determines the minimum
regulatory capital. Vice versa, a given regulatory capital limits risk-bearing credit and
trading transactions of a bank. Therefore, banks have an incentive to look for capital
relief, for example by using credit derivatives.
At its inception, this first approach to a risk-based supervisory process represented an
innovative and intelligent way of regulation. In the meantime, however, a rapid technolog-
ical and financial evolution has taken place, undermining the effectiveness of regulation.
This development demanded a new, modern framework taking into account the increasing
number of complex financial products, other forms of risk such as operational risk, and
risk weights better aligned with actual risk inherent in a bank’s assets.
Basel II Accord
In 2004, a new Capital Accord for international operating banks, the Basel II Accord, was
passed. It constitutes a framework based on three pillars: Minimum capital requirements,
supervisory review process and enhanced disclosure. The Accord has to be implemented
by the signatory countries by the end of 2006. It can be considered as a milestone for the
international harmonisation of regulation. It has to overcome weaknesses of Basel I such as
2 See [BK04], p. 376 and [Sch03], pp. 2-3.
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