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Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules

Author

Listed:
  • Vincenzo Russo

    (Assicurazioni Generali S.p.A.)

  • Valentina Lagasio

    (University of Rome “La Sapienza”)

  • Marina Brogi

    (University of Rome “La Sapienza”)

  • Frank J. Fabozzi

    (EDHEC Business School)

Abstract

In this paper, we estimate the probability of a financial institution breaching the Common Equity Tier 1 capital under Basel III rules. We do so by applying the Merton model, where balance sheet data and market data are used to match the probability of default implied by the model with the probability of default implied by market quotations for credit default swaps. We provide an empirical analysis for several banks classified by the Financial Stability Board and the Basel Committee on Banking Supervision as Global Systemically Important Financial Institutions, evaluating how the probability of breaching the Common Equity Tier 1 Capital evolved from 2005 to 2015. We find that higher Common Equity Tier 1 Capital ratios do not necessarily imply lower probabilities of breaching capital requirements and vice versa. We also focus on the asset volatility calibrated according to our model and we find that it appears to be a good proxy for the risk-weighted asset density.

Suggested Citation

  • Vincenzo Russo & Valentina Lagasio & Marina Brogi & Frank J. Fabozzi, 2020. "Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules," Annals of Finance, Springer, vol. 16(1), pages 141-157, March.
    • Handle: RePEc:kap:annfin:v:16:y:2020:i:1:d:10.1007_s10436-020-00358-0
    DOI: 10.1007/s10436-020-00358-0
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    Cited by:

    1. Daniel Dimitrov & Sweder van Wijnbergen, 2023. "Macroprudential Regulation: A Risk Management Approach," Working Papers 765, DNB.
    2. Bianca Reichert & Adriano Mendon a Souza, 2022. "Can the Heston Model Forecast Energy Generation? A Systematic Literature Review," International Journal of Energy Economics and Policy, Econjournals, vol. 12(1), pages 289-295.
    3. Marina Brogi & Valentina Lagasio & Luca Riccetti, 2021. "Systemic risk measurement: bucketing global systemically important banks," Annals of Finance, Springer, vol. 17(3), pages 319-351, September.
    4. Giuliana Birindelli & Paola Ferretti & Giovanni Ferri & Marco Savioli, 2022. "Regulatory reform and banking diversity: reassessing Basel 3," Annals of Finance, Springer, vol. 18(4), pages 429-456, December.
    5. Piotr Jaworski & Kamil Liberadzki & Marcin Liberadzki, 2021. "On Write-Down/ Write-Up Loss Absorbing Instruments," European Research Studies Journal, European Research Studies Journal, vol. 0(1), pages 1204-1219.

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    More about this item

    Keywords

    Probability of breaching; Basel III rules; Merton model; Credit default swap; Global Systemically Important Financial Institutions;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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