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99.9% – really?

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  • Kiema, Ilkka

    ()
    (University of Helsinki)

  • Jokivuolle, Esa

    ()
    (Bank of Finland Research)

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    Abstract

    The aim of the Internal Ratings Based Approach (IRBA) of Basel II was that capital suffices for unexpected losses with at least a 99.9% probability. However, because only a fraction of the required regulatory capital (a quarter to a half) had to be loss absorbing capital, the actual solvency probabilities may have been much lower, as the global financial crisis illustrates. Our estimates suggest that under Basel II IRBA the loss-absorbing capital of an average-quality portfolio bank suffices for unexpected losses with a 95%-99% probability. This translates into an expected bank failure rate as high as once in twenty years. Even if the bank's interest income is incorporated into our model, the expected failure rate is still substantial. We show that the expected failure rate increases with loan portfolio riskiness. Our calculations may be viewed as a measure of regulatory "self-delusion" included in Basel II capital requirements.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/BoF_DP_1325.pdf
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    Bibliographic Info

    Paper provided by Bank of Finland in its series Research Discussion Papers with number 25/2013.

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    Length: 42 pages
    Date of creation: 09 Oct 2013
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2013_025

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    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: capital requirements; IRBA; Basel II; financial crisis;

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    References

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    1. Michael B. Gordy, 1998. "A comparative anatomy of credit risk models," Finance and Economics Discussion Series 1998-47, Board of Governors of the Federal Reserve System (U.S.).
    2. Repullo, Rafael & Suarez, Javier, 2003. "Loan Pricing Under Basel Capital Requirements," CEPR Discussion Papers 3917, C.E.P.R. Discussion Papers.
    3. Gordy, Michael B., 2003. "A risk-factor model foundation for ratings-based bank capital rules," Journal of Financial Intermediation, Elsevier, vol. 12(3), pages 199-232, July.
    4. Chiappori, Pierre-Andre & Perez-Castrillo, David & Verdier, Thierry, 1995. "Spatial competition in the banking system: Localization, cross subsidies and the regulation of deposit rates," European Economic Review, Elsevier, vol. 39(5), pages 889-918, May.
    5. Robert Hauswald & Robert Marquez, 2006. "Competition and Strategic Information Acquisition in Credit Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 967-1000.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Self-delusion in Basel II
      by Economic Logician in Economic Logic on 2013-11-13 15:49:00

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