Cyclical implications of the Basel II capital standards

One of the central changes proposed as part of the new Basel II regulatory framework is the concept of internal- rating-based (IRB) capital requirements.1 Under the IRB approach, the amount of capital that a bank will have to hold against a given exposure will be a function of the estimated credit risk of that exposure. Estimated credit risk in turn is taken to be a predetermined function of four parameters: probability of default (PD), loss given default (LGD), exposure at default (EAD), and maturity (M). Banks operating under the “Advanced” variant of the IRB approach will be responsible for providing all four of these parameters themselves, based on their own internal models. Banks operating under the “Foundation” variant of the IRB approach will be responsible only for providing the PD parameter, with the other three parameters to be set externally by the Basel committee.2