Tests on the Accuracy of Basel II

Abstract: Basel II rules allow qualified banks to assess the risk in their portfolio of credit exposures with a methodology based on the informational content of credit ratings and two crucial assumptions: (1) the credit risk of individual exposures is driven by one systematic risk factor only and (2) the portfolio is fully diversified. We test the accuracy of the credit risk measures obtained with the new rules by comparing them with benchmark measures derived with a popular ratings-based credit risk model which accounts for multiple risk factors and portfolio concentration. We find that the Basel II assumptions may have a substantial impact on risk assessments and produce deviations from the benchmark that may be economically significant.