The Basel II accord emphasizes risk sensitiveness for the capital of commercial banks. It recommends two methods—Standardized Approach and Internal Rating Based (IRB) Approach—for the estimation of risk capital requirements. Whereas, the former approach is based on external credit ratings, the latter uses estimates of Probability of Default (PD). To assess the appropriateness of these approaches for risk capital estimation, this study employs the Merton's Option Pricing Model to estimate the PDs for different firms in India. The authors estimate PDs on a sample of 67 Indian firms during the period 1998-2004. The results obtained show that the credit ratings accorded by Indian agencies have poor discriminating power in terms of the PDs. This finding suggests that the credit ratings may not accurately lead to a correct assessment of risk capital requirement as prescribed under the standardized approach. Further, as the yearly PDs for the firms do not show any significant pattern and exhibit high volatility, the estimates of capital requirement would also be highly volatile under the IRB approach. Either it is underestimated or overestimated. However, the results of the study are only tentative as the PDs estimated using the Merton's model are highly influenced by the volatility in the equity prices that is not necessarily connected to the probability of default.

The Basel Committee for estimating their minimum capital requirements, proposes to permit the banks, a choice between two broad methodologies, i.e., standardized approach and IRB approach. The standardized approach, estimates the risk capital using external credit ratings, whereas the IRB approach uses internal rating systems on probabilities of default to estimate the risk capital. The risk weights under the standardized approach are determined using assessments by external credit rating institutions, which are recognized as eligible for capital purposes by national supervisors. In general, depending on the credit ratings, the banks may have to provide for risk weights ranging from a minimum of 0% to a maximum of 150%.

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