Dimensions of Credit Risk and Their Relationship to Economic Capital Requirements

Now in prospect is a major revision of international bank capital regulations that would embody recent advances in credit risk measurement and management. Previous regulations have been simpler in structure, with a primary goal of getting capital requirements right on average, and thus have largely ignored the difference between average and marginal. This paper presents evidence that explicit treatment in new regulations of several important dimensions of credit risk is necessary. If such dimensions are compressed or ignored, capital arbitrage activities by banks are likely to continue, leading to an increase in bank failure rates over time.