The capital requirements formula within the Basel II Accord is based on a Merton one factor model and in the case of credit cards an asset correlation of 4% is assumed. In this paper we estimate the asset correlation for two datasets assuming the one factor model. The datasets relate to a national sample of credit card accounts and the second to a specific credit card portfolio. We show that the asset correlations assumed by Basel II are much higher than those observed in the datasets we analyse. We also segment one of the datasets and show the variation in asset correlations between risk segments. We also show the reduced importance of unobserved factors in explaining default patterns when observable, as opposed to unobservable, macroeconomic factors are included in the model. We then show the reduction in capital requirements that a typical lender would have if the values we estimated were implemented in the Basel Accord in place of the current values.
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