A model of bank reserves with macroeconomic and financial corrections

Working papers | 2007 | N 29

Abstract

The publication of the second banking regulation document by the Bank for International Settlement (BIS), opened the door for banking institutions to develop models of increasing complexity for the calculation of their capital requirements as protection against credit risk. Models based on Internal Ratings (IRB) were classified as simple and advanced based on the parameters to be estimated by the entity and those determined by the regulator. The default rate and loss given default must be calculated internally for the model to be considered advanced. This model leaves aside a priori considerations and establishes default rates based on historical information. On the other hand, far from homogenizing credit categories, it has been assumed that there is internal variability for default rates within the same stratum. Finally, these rates were corrected using a proportional risks model to reflect the economic situation and allow the entity to save an amount of reserves in line with default expectations. Once these facts were considered, the model was simulated obtaining an estimate of the average loss of the portfolio and consequently the reserve ratio.