AssessingAlternativeAssumptionsonDefaultRiskCapitalinthe.doc

Assessing Alternative Assumptions on Default Risk Capital in the Trading Book December 12, 2006 Gary Dunn: UK Financial Services Authority Michael Gibson: Federal Reserve Board Gloria Ikosi: Federal Deposit Insurance Corporation Jonathan Jones: Office of Thrift Supervision Charles Monet: US Securities and Exchange Commission Michael Sullivan: Office of the Comptroller of the Currency I. Objective In this paper, we illustrate the range of potential default losses for trading books across a range of possible assumptions. These results are also compared with A-IRB capital requirements. The intent of this analysis is not to specify the “correct” set of assumptions for computing default risk in the trading book, since each firm will make its own assumptions in modeling default losses in its trading book. Instead, we examine the sensitivity of default risk capital to the choice of alternative modeling assumptions. The Revised Accord requires firms to model incremental default risk in the trading book. In this paper, we consider only capital for default risk and do not consider the impact of adjustments for double counting of default risk and spread risk. We will consider this issue in a separate analysis, which we intend to prepare in the near future. II. Summary of Findings Disclaimer: These results are indicative rather than authoritative. We used a standard default process model but there are uncertainties in the input parameters, limitations of data and various numerical approximations that affect the quality of the results. In addition, a narrow range of portfolios are investigated. Liquidity Horizon: Adjusting for liquidity effects using ratings data implies that going from a 12-month liquidity horizon to a 1-month liquidity horizon while keeping a 12-month capital horizon reduces capital around 30% while using a simple market based approach reduces capital around 40%. In comparison, the ratings-based approach reduces capital around 20% when moving from a 12 mo