The internal ratings-based (IRB) approach recently proposed by the Basel Supervisors Committee (BCBS) seeks to make regulatory capital requirements for banks approximate economic capital requirements (Basel 2001). Under certain assumptions (Gordy 2000), IRB capital requirements would vary across banks according to the riskiness of their portfolios in a manner that would make the likelihood of insolvency approximately constant for all banks that are at the regulatory minimum. Thus, required capital would be larger for banks with portfolios posing greater risks of large losses and smaller for banks with less risky portfolios. The IRB capital formula for credit risk takes as inputs loan and portfolio characteristics and produces capital requirements. Designing such a formula involves decisions about 1) the dimensions of credit risk to be included, that is, which loan and portfolio characteristics should appear as variables in the formula; 2) the relative variations in capital requirements as loan and portfolio characteristics vary from those of a reference or numeraire loan or portfolio; and 3) the absolute level of capital required for the numeraire portfolio
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