How a credit run affects asset correlation

Abstract

This paper analyses the effect of soaring demand in the lending market shortly before a fi nancial crisis (hereinafter "credit run"). A credit run affects the asset correlation, which is one of the main parameters in the Internal Ratings-Based Approach (IRBA) of the Basel III framework. In the framework, these coefficients are predetermined and have not been recalibrated since their introduction in the Basel II Accord. This paper not only questions the assumption of a constant asset correlation, which is a fundamental part of the theoretical foundation of the IRBA, but also shows that a credit run increases the asset correlation value through a new approach. Thereby, this paper offers evidence that the asset correlations given in the IRBA are underestimated. In contrast to other asset correlation studies, this paper provides a new approach which is compatible with the foundation of the IRBA. Assuming asset correlations are calibrated correctly in the IRBA, a 2% downturn add-on may be adequate.