We contribute to the debate over the reform of the Basel Accord by developing risk-based capital requirements for mortgage loans held in portfolio by financial intermediaries. Our approach employs simulation of both economic variables that affect default incidence and conditional loss probability distributions. Results indicate that appropriate capital charges for credit risk vary substantially with loan characteristics and portfolio geographic diversification. Hence, rules that offer little risk differentiation, including the current Basel I regime and “standardized” approach proposed in Basel II result in significant divergence between regulatory and economic capital. These results highlight the incentive problems inherent in simplified methods of capital regulation.

Although credit history scoring offers benefits to lenders and borrowers, failure to consider situational circumstances raises important statistical issues that may affect the ability of scoring systems to accurately quantify an individual’s credit risk. Evidence from a national sample of credit reporting agency records suggests that failure to consider measures of local economic circumstances and individual trigger events when developing credit history scores can diminish the potential effectiveness of such models. There are practical difficulties, however, associated with developing scoring models that incorporate situational data, arising largely because of inherent limitations of the credit reporting agency databases used to build scoring models.