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The Basel II Risk-Weighted Assets Formula

Michael Walker
walker@physics.utoronto.ca
2004/02/02
Vasicek1 considers the fractional number of defaults in a portfolio of a large number of risky
correlated loans. He finds that the probability that the fractional number of defaults is less that is

1 RN 1 () N 1 (P D)

W () = N
.
R
where P D is the probability of default on a single loan and R is the correlation parameter, assumed
the same for all pairs of loans.
Define the fractional defaults at risk, F DaR, to be the fractional number of defaults that will
not be exceeded within a 99.9% confidence level. Then
W (F DaR) = 0.999
Solving for F DaR gives
"

N 1 (P D) + RN 1 (0.999)
p
F DaR = N
.
(1 R)
As stated above, this calculation is valid in the limit that the number of loans in the portfolio
becomes very large. In this limit, and in the absence of correlation (i.e. R 0) the binomial
distribution for the fractional number of defaults is accurately described by a one-point density
with its weight concentrated at = P D. Thus F DaR = P D. Also, for very strong correlation
(i.e. R 1), the distribution of fractional defaults is described by a two-point density with weight
1 P D at = 0 and weight P D at = 1. Thus F DaR = 1 for P D > 0.001, while F DaR = 0 for
P D < 0.001. These intuitive results are in agreement with those of the above formula.
The Basel II formula for (corporate, etc.) risk-weighted assets is now
Risk-Weighted Assets = 12.50 F DaR LGD EAD M atAd,
where LGD is the loss given default, EAD is the exposure at default, and M atAd is a maturity
adjustment. Taking 8% of the risk-weighted assets gives the maximum loss at the 99.9% confidence
level, and the required buffer capital is set equal to this loss.
The formula for the correlation parameter given in Basel II, which has an empirical basis,2 can
be simplified to
R = 0.12[1 + exp(50P D)].
The maturity adjustment given in Basel II has the form
M atAd =
where

1 + (M 2.5) b P D
1 1.5 b P D

b = [0.08451 0.05898 log(P D)]2 .

Here M is an effective maturity, constrained to lie between one year and 5 years (IRB approach).
In the calculation of F DaR, losses are deemed to occur only in the event of default. However, it is
clear that when, say, a two-year AA-rated loan downgrades after one year to grade BB, there are
also credit losses which should be taken into account.3 There is of course no such adjustment, i.e.
M atAd = 1, when the effective maturity M equals the time horizon of one year. This intuition is
in agreement with the above formula for M atAd.
1

O. Vasicek, Probability of Loss on a Loan Portfolio, KMV (1987,1991).


Jose A. Lopez, The Empirical Relationship between Average Asset Correlation, Firm Probability of
Default and Asset Size, (find using Google).
3
Michael B Gordy, A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules, J. Financial Intermediation 12, 199 (2003).
2

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