Integrated models of capital adequacy - Why banks are undercapitalised
AbstractWith the majority of large UK and many US banks collapsing or being forced to raise capital over the 2007-9 period, blaming bankers may be satisfying but is patently insufficient; Basel II and Federal oversight frameworks also deserve criticism. We propose that the current methodological void at the heart of Basel II, Pillar 2 is filled with the recommendation that banks develop fully-integrated models for economic capital that relate asset values to fundamental drivers of risk in the economy to capture systematic effects and inter-asset dependencies in a way that crude correlation assumptions do not. We implement a fully-integrated risk analysis based on the balance sheet of a composite European bank using an economic-scenario generation model calibrated to conditions at the end of 2007. Our results suggest that the more modular, correlation-based approaches to economic capital that currently dominate practice could have led to an undercapitalisation of banks, a result that is clearly of interest given subsequent events. The introduction of integrated economic-scenario-based models in future can improve capital adequacy, enhance Pillar 2's application and rejuvenate the relevance of the Basel regulatory framework.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Banking & Finance.
Volume (Year): 34 (2010)
Issue (Month): 12 (December)
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Web page: http://www.elsevier.com/locate/jbf
Risk management Economic capital Enterprise risk management Basel II Solvency II Stochastic models Stress testing;
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