Analysis of PD-LGD correlation effects on the minimum capital requirement

Abstract

The minimum capital requirement in the Basel II IRB approach implicitly assumes that the risk factors involved in PD and LGD are independent. This thesis analyses and quantifies the effects on the minimum capital requirement under the presence of correlation between the factors affecting PD and LGD. The same portfolio is simulated with different PD-LGD correlation and the minimum capital requirement in the IRB approach is computed with two different sets of risk factors: the real an correlated PD and LGD and the PD and LGD that will be estimated with the usual modeling approach. The main conclusions is that as the dependency between PD and LGD grows, the minimum capital is more underestimated.