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Macro-model-based stress testing of Basel II capital requirements

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Author Info

  • Jokivuolle, Esa

    ()
    (Bank of Finland Research)

  • Virolainen, Kimmo

    ()
    (Financial Markets and Statistics Department)

  • Vähämaa, Oskari

    ()
    (Bank of Finland Research)

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    Abstract

    Basel II framework requires banks to conduct stress tests on their potential future minimum capital requirements and consider ‘at least the effect of mild recession scenarios’. We propose a stress testing framework for minimum capital requirements in which banks’ corporate credit risks are modeled with macroeconomic variables. We can thus define scenarios such as a mild recession and consider the resulting credit risk developments and consequent changes in minimum capital requirements. We also emphasize the importance of stress testing future minimum capital requirements jointly with credit losses. Our illustrative results based on Finnish data underline the importance of such joint modeling. We also find that stress tests based on scenarios envisaged by regulators are not likely to imply binding capital constraints on banks.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0717netti.pdf
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    Bibliographic Info

    Paper provided by Bank of Finland in its series Research Discussion Papers with number 17/2008.

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    Length: 27 pages
    Date of creation: 02 Sep 2008
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2008_017

    Contact details of provider:
    Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/
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    Related research

    Keywords: Basel II; capital requirements; credit risk; loan losses; stress tests;

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    References

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    1. Heid, Frank, 2007. "The cyclical effects of the Basel II capital requirements," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3885-3900, December.
    2. Allen Berger & Robert DeYoung & Mark Flannery & David Lee & Ozde Oztekin, 2008. "How do large banking organizations manage their capital ratio?," Research Working Paper RWP 08-01, Federal Reserve Bank of Kansas City.
    3. Samu Peura & Esa Jokivuolle, 2004. "Simulation-based stress testing of banks’ regulatory capital adequacy," Finance 0405003, EconWPA.
    4. Virolainen , Kimmo, 2004. "Macro stress testing with a macroeconomic credit risk model for Finland," Research Discussion Papers 18/2004, Bank of Finland.
    5. Peura, Samu & Jokivuolle, Esa, 2003. "Simulation-based stress testing of banks’ regulatory capital adequacy," Research Discussion Papers 4/2003, Bank of Finland.
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    Cited by:
    1. Andersen, Henrik, 2011. "Procyclical implications of Basel II: Can the cyclicality of capital requirements be contained?," Journal of Financial Stability, Elsevier, vol. 7(3), pages 138-154, August.

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