Previously I wrote about an approach to pricing loans, where the spread is set to cover expected losses from default, and to make a return on capital allocated. In this article I use the framework to explore the drivers of credit spreads that banks would calculate if they used the Basel IRB formula to calculate the amount of capital required.

Some banks may use regulatory capital to derive capital as this reflects the amount of regulatory capital required for the loan. The regulatory approach as specified by BCBS captures key drivers of risk such as probability of default, loss given default, systemic risk, and term.

This simple pricing approach reveals some interesting dynamics of the required credit spread. For example, with higher rated securities, the spread is driven by capital requirements and not the expected loss. Drivers of capital such as correlation between defaults and term to maturity have a larger influence.

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