Retail Loans and Basel II: Using Portfolio Segmentation to Reduce Capital Requirements

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Daniel Kaltofen, Stephan Paul, Stefan Stein

The key concept underlying the Basel II framework for risk measurement and corresponding equity capital standards is that the existing regulations pertaining to credit risk will be individualised through reference to the internal ratings of banks.

In accordance with the regulatory guidelines, Daniel Kaltofen, Stephan Paul and Stefan Stein develop an ‘optimised segmentation approach’ with regard to the credit default event and measure the implications for regulatory capital requirements.

As regards methodology, they present an innovative technique and test it on a data set of approximately 413,000 motor vehicle loans. By classifying loans according to selective predictors of default, the authors find that banks can achieve significant savings in terms of ensuring a lower regulatory capital requirement. This provides banks with the opportunity to increase lending capacity. The technique overcomes the disadvantages of the more familiar standard methods used in today’s bank risk management and delivers more robust results.