the LGD increases, although the PD decreases offset the LGD increases so as to keep
expected losses constant.
BIS II is based on a prespecified threshold insolvency level; that is, capital levels
are set so that the estimated probability of insolvency of each bank is lower than a
threshold level such as 99.9% (or 0.1% probability of failure per year, or one bank
insolvency every 1,000 years).^51 However, there are two potential shortcomings to
this approach from the regulator’s point of view. First, without considering the rela-
tionship between individual banks’ insolvency probabilities. BIS II cannot specify an
aggregate, system-wide insolvency risk threshold (see Acharya (2001)). Second,
there is no information about the magnitude of loss given bank insolvency. The de-
posit insurer, for example, may be concerned about the cost to the deposit insurance
fund in the event that the bank’s capital is exhausted. (See Gordy (2000) for a dis-
cussion of the estimation of the “expected tail loss.”) BIS II addresses neither of these
concerns. However, there is evidence (see Jackson et al. (2001)) that banks hold cap-
ital in excess of the regulatory minimum in response to market pressure; for exam-
ple, in order to participate in the swap market, the bank’s credit quality must be
higher than would be induced by complying with either BIS I or II.^52 Thus, regula-
tory capital requirements may be considered lower bounds that do not obviate the
need for more precise credit risk measurement.
3.6 SUMMARY. The new Basel Accord on bank capital (BIS II) makes capital re-
quirements more sensitive to credit risk exposure. Regulations governing minimum
capital requirements allow the bank to evolve through three steps: (1) The Standard-
3.5 SUMMARY 3 • 17Actual Advanced Advanced
BIS II LGD PD% IRB Risk IRB Risk
Risk Altman & Altman & Increased Decreased Weight Weight
Buckets Saunders Saunders LGD PD% Altman & using cols.
(1) (2) (3) (4) (5) Saunders (4) & (5)
AAA–AA– 0 0 0 0 0 0
A+ A– 20.714 0.058 25 0.048 3.585 4.327
BBB+ BB– 18.964 0.857 20 0.813 16.315 17.206
Below BB– 28.321 9.787 35 7.919 153.063 189.160
Notes:The LGD and PD values in columns (2) and (3) are taken from Altman and Saunders
(2001b). The LGD and PD values in columns (4) and (5) are adjusted to increase LGD while
keeping expected losses (LGD ×PD) constant).
Exhibit 3.8. The Impact of Increases in LGD on Advanced Internal Ratings–Based Risk
Weights under BIS II Holding Expected Losses Constant
(^51) Jackson et al. (2001) show that BIS II is calibrated to achieve a confidence level of 99.96% (i.e., an
insolvency rate of 0.4%), whereas banks choose a solvency standard 99.9% in response to market pres-
sures. This conforms to observations that banks tend to hold capital in excess of regulatory requirements.
(^52) Jackson et al. (2001) find that a decrease in the bank’s credit rating from A+ to A would reduce swap
liabilities by approximately £2.3 billion.