The Marginal Impact of Granularity on Banks? Credit Risk Capital Charge

This paper aims to evaluate the fine-grained assumption implied in the formula specified by the Bank for International Settlements Basel Committee on Banking?s internal-ratings based (IRB) approach under Pillar 1 of Basel II: minimum capital requirement. We compared the regulatory capital charge under Basel II with true unexpected loss approximated by Monte-Carlo simulations. We showed that the fine-grained assumption in IRB formula would cause regulatory capital charge to deviate from the true unexpected loss when there is concentration in the portfolio. Meanwhile, the IRB approach gives misleading information on the risk contribution of added large loans with low probability of default, which could be exploited by banks as a means to increase risk concentrations while holding lower regulatory capital. Moreover, as both the Monte-Carlo simulation and IRB formula are Value at Risk (VaR) approaches, we set out to discuss the limitation of using VaR as a risk measure by looking at a special case where VaR seems to lose credibility. We suggested two alternatives to account for this deficiency.