20/02/2013

Basel II IRB Risk Weight Functions (Février 2013) by Benoît GENEST & Léonard BRIE

Regulatory capital requirements pose a major challenge for financial institutions today.

As the Asian financial crisis of 1997 and rapid development of credit risk management revealed many shortcomings and loop holes in measuring capital charges under Basel I, Basel II was issued in 2004 with the sole intent of improving international convergence of capital measurement and capital standards.

This paper introduces Basel II, the construction of risk weight functions and their limits in two sections:

In the first, basic fundamentals are presented to better understand these prerequisites: the likelihood of losses, expected and unexpected loss, Value at Risk, and regulatory capital. Then we discuss the founding principles of the regulatory formula for risk weight functions and how it works.

The latter section is dedicated to studying the different parameters of risk weight functions, in order to discuss their limits, modifications and impacts on the regulatory capital charge coefficient.

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