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Regulatory and 'economic' solvency standards for internationally active banks

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  • Patricia Jackson
  • William Perraudin
  • Victoria Saporta

Abstract

One of the most important policy issues for financial authorities is to decide at what level average capital charges should be set. The decision may alternatively be expressed as the choice of an appropriate survival probability for representative banks over a horizon such as a year, often termed a solvency standard. In this paper, light is shed on the solvency standards implied by current and possible future G10 bank regulation, and on the economic solvency standard that banks choose themselves by their own capital-setting decisions. In particular, a credit risk model is employed to show that the survival probability implied by the 1988 Basel Accord is between 99.0% and 99.9%. It is then demonstrated that if a new Basel Accord were calibrated to such a standard, it would not represent a binding constraint on banks' current operations, since most banks employ a solvency standard significantly higher than 99.9%. To show this, a statistical analysis of bank ratings is employed, adjusted for the impact of official or other support, as well as credit risk model calculations. Lastly, a possible explanation is advanced for the conservative capital choices made by banks, by showing that swap volumes are highly correlated with credit quality for given bank size. This suggests that banks' access to important credit markets like the swap markets may provide a significant discipline in the choice of solvency standard.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 161.

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Date of creation: Aug 2002
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Handle: RePEc:boe:boeewp:161

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  1. Ronn, Ehud I. & Verma, Avinash K., 1989. "Risk-based capital adequacy standards for a sample of 43 major banks," Journal of Banking & Finance, Elsevier, vol. 13(1), pages 21-29, March.
  2. Pamela Nickell & William Perraudin & Simone Varotto, 2001. "Ratings versus equity-based credit risk modelling: an empirical analysis," Bank of England working papers 132, Bank of England.
  3. Vijay Bhasin, 1995. "On the credit risk of OTC derivative users," Finance and Economics Discussion Series 95-50, Board of Governors of the Federal Reserve System (U.S.).
  4. Simonne Varotto, 2001. "Credit Risk Diversification," ICMA Centre Discussion Papers in Finance icma-dp2001-07, Henley Business School, Reading University.
  5. Pamela Nickell & William Perraudin & Simone Varotto, 2001. "Stability of ratings transitions," Bank of England working papers 133, Bank of England.
  6. Gordy, Michael B., 2000. "A comparative anatomy of credit risk models," Journal of Banking & Finance, Elsevier, vol. 24(1-2), pages 119-149, January.
  7. Milne, Alistair, 2002. "Bank capital regulation as an incentive mechanism: Implications for portfolio choice," Journal of Banking & Finance, Elsevier, vol. 26(1), pages 1-23, January.
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Cited by:
  1. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P. Tsomocos, 2003. "Procyclicality and the new Basel Accord–banks’ choice of loan rating system," LSE Research Online Documents on Economics 24863, London School of Economics and Political Science, LSE Library.
  2. Jose Lopez, 2009. "Empirical analysis of the average asset correlation for real estate investment trusts," Quantitative Finance, Taylor & Francis Journals, vol. 9(2), pages 217-229.
  3. Pierpaolo Ferrari, 2004. "La gestione del capitale nelle banche e l' utilizzo degli strumenti innovativi di patrimonializzazione: un' analisi comparata internazionale," Moneta e Credito, Economia civile, vol. 57(225), pages 31-76.
  4. Abel Elizalde & Rafael Repullo, 2007. "Economic and Regulatory Capital in Banking: What Is the Difference?," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 87-117, September.
  5. Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
  6. Jaap Bikker & Paul Metzemakers, 2004. "Is bank capital procyclical? A cross-country analysis," DNB Working Papers 009, Netherlands Central Bank, Research Department.
  7. Jokivuolle , Esa & Peura , Samu, 2006. "Rating targeting and the confidence levels implicit in bank capital," Research Discussion Papers 27/2006, Bank of Finland.
  8. Sundmacher, Maike & Ellis, Craig, 2011. "Bank 'ratings arbitrage': Is LGD a blind spot in economic capital calculations?," International Review of Financial Analysis, Elsevier, vol. 20(1), pages 6-11, January.
  9. Bertrand Rime, 2003. "The New Basel Accord: Implications of the Co-existence between the Standardized Approach and the Internal Ratings-based Approach," Working Papers 03.05, Swiss National Bank, Study Center Gerzensee.
  10. Glenn Hoggarth & Andrew Logan & Lea Zicchino, 2005. "Macro stress tests of UK banks," BIS Papers chapters, in: Bank for International Settlements (ed.), Investigating the relationship between the financial and real economy, volume 22, pages 392-408 Bank for International Settlements.

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