Economic capital for credit risk in the trading book

Abstract

The Basel II accord sets out detailed formulations (in its Internal Ratings Based approaches) for determining credit risk capital in the banking book, but until recently, credit risk in the trading book was largely ignored. The financial crisis in 2007/08 exposed this oversight: woefully inadequate trading book capital led to considerable losses which resulted in, inter alia, the imposition of severe capital requirements on credit riskprone securities in the trading book. Using empirical loss data, this article investigates whether these requirements are appropriate for the trading book and proposes a possible alternative which banks may use to determine economic capital.