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Simulation-based stress testing of banks’ regulatory capital adequacy

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Author Info
Samu Peura (Sampo plc, Finland)
Esa Jokivuolle (Helsinki School of Economics, Department of Accounting & Finance)

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Abstract

Banks’ holding of reasonable capital buffers in excess of minimum requirements could alleviate the procyclicality problem potentially exacerbated by the rating-sensitive capital charges of Basel II. Determining the required buffer size is an important risk management issue for banks, which the Basle Committee (2002) suggests should be approached via stress testing. We present here a simulation-based approach to stress testing of capital adequacy where rating transitions are conditioned on business-cycle phase and business-cycle dynamics are taken into account. Our approach is an extension of the standard credit portfolio analysis in that we simulate actual bank capital and minimum capital requirements simultaneously. Actual bank capital (absent mark- to-market accounting) is driven by bank income and default losses, whereas capital requirements within the Basel II framework are driven by rating transitions. The joint dynamics of these determine the necessary capital buffers, given bank management’s specified confidence level for capital adequacy. We provide a tentative calibration of this confidence level to data on actual bank capital ratios, which enables a ceteris- paribus extrapolation of bank capital under the current regime to bank capital under Basel II.

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Paper provided by EconWPA in its series Finance with number 0405003.

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Date of creation: 03 May 2004
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Handle: RePEc:wpa:wuwpfi:0405003

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Related research
Keywords: Basel II; Pillar 2; bank capital; stress tests; procyclicality;

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Find related papers by JEL classification:
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Milne, Alistair & Robertson, Donald, 1996. "Firm behaviour under the threat of liquidation," Journal of Economic Dynamics and Control, Elsevier, vol. 20(8), pages 1427-1449, August. [Downloadable!] (restricted)
  2. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios P. Tsomocos, 2002. "Procyclicality and the New Basel Accord: banks' choice of loan rating system," Conference Series ; [Proceedings], Federal Reserve Bank of Boston. [Downloadable!]
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  3. Holt, Richard W. P., 2003. "Investment and dividends under irreversibility and financial constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 27(3), pages 467-502, January. [Downloadable!] (restricted)
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  4. Con Keating & Hyun Song Shin & Charles Goodhart & Jon Danielsson, 2001. "An Academic Response to Basel II," FMG Special Papers sp130, Financial Markets Group. [Downloadable!] (restricted)
  5. Anil Bangia & Francis X. Diebold & Til Schuermann, 2000. "Ratings Migration and the Business Cycle, With Application to Credit Portfolio Stress Testing," Center for Financial Institutions Working Papers 00-26, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
    Other versions:
  6. Bhattacharya, Sudipto & Plank, Manfred & Strobl, Gunter & Zechner, Josef, 2002. "Bank capital regulation with random audits," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1301-1321, July. [Downloadable!] (restricted)
    Other versions:
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Guender, Alfred V., 2003. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Research Discussion Papers 12/2003, Bank of Finland. [Downloadable!]
    Other versions:
  2. David T. Llewellyn & David G. Mayes, 2004. "The role of market discipline in handling problem banks," Finance 0404020, EconWPA. [Downloadable!]
    Other versions:
  3. Vauhkonen , Jukka, 2003. "Financial contracts and contingent control rights," Research Discussion Papers 14/2003, Bank of Finland. [Downloadable!]
  4. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA. [Downloadable!]
  5. Kauko, Karlo, 2003. "Interlinking securities settlement systems: A strategic commitment?," Research Discussion Papers 26/2003, Bank of Finland. [Downloadable!]
  6. Vauhkonen, Jukka, 2003. "Are adverse selection models of debt robust to changes in market structure?," Research Discussion Papers 28/2003, Bank of Finland. [Downloadable!]
  7. Mark Illing & Graydon Paulin, 2004. "The New Basel Capital Accord and the Cyclical Behaviour of Bank Capital," Working Papers 04-30, Bank of Canada. [Downloadable!]
  8. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA. [Downloadable!]
  9. Vauhkonen , Jukka, 2003. "Banks' equity stakes in borrowing firms: corporate finance approach," Research Discussion Papers 13/2003, Bank of Finland. [Downloadable!]
  10. Hege, Ulrich & Feess, Eberhard, 2007. "Basel II and the Value of Bank Differentiation," Les Cahiers de Recherche 879, HEC Paris. [Downloadable!]
  11. Eberhard Feess & Ulrich Hege, 2004. "The Basel II Accord: Internal Ratings and Bank Differentiation," CFS Working Paper Series 2004/25, Center for Financial Studies. [Downloadable!]
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