What are the methods of measuring credit risk and their consequences?
The paper presents an analytical framework to measure the aggregation of credit risk under the standard method proposed in Basle Committee guidelines. Results from Peru indicate that the standard method would overestimate credit risk, leading Peruvian banks to maintain higher capital levels than would otherwise at the expense of operations and welfare by reducing the level of resources to the rest of the economy. However the method may provide an additional cushion against bad loans if that is necessary.
As of December 1998, this over-estimation would have produced the immobilization of US $316 million in capital and an estimated welfare loss of US $853 million, while providing an ability to assist up to US $3.6 billion in troubled assets. When compared to the alternative, the standard method becomes a more attractive option as the need for additional net capital grows above 15%. Therefore, the perception of what capital level is needed is key to determine which method is recommendable.
The standard method is expected to continue to be the choice of regulators in the near future.