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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)

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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File URL: http://128.118.178.162/eps/fin/papers/0405/0405003.pdf
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Bibliographic Info

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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Web page: http://128.118.178.162

Related research

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

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References

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  1. Dimitrios P Tsomocos & Eva Catarineu-Rabell, 2003. "Procyclicality and the new Basel Accord - Banks` choice of loan rating system," Economics Series Working Papers 2003-FE-06, University of Oxford, Department of Economics.
  2. Bhattacharya, Sudipto & Plank, Manfred & Strobl, Günter & Zechner, Josef, 2000. "Bank Capital Regulation with Random Audits," CEPR Discussion Papers 2597, C.E.P.R. Discussion Papers.
  3. 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.
  4. Con Keating & Hyun Song Shin & Charles Goodhart & Jon Danielsson, 2001. "An Academic Response to Basel II," FMG Special Papers sp130, Financial Markets Group.
  5. 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.
  6. Bangia, Anil & Diebold, Francis X. & Kronimus, Andre & Schagen, Christian & Schuermann, Til, 2002. "Ratings migration and the business cycle, with application to credit portfolio stress testing," Journal of Banking & Finance, Elsevier, vol. 26(2-3), pages 445-474, March.
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Citations

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Cited by:
  1. Mark Illing & Graydon Paulin, 2004. "The New Basel Capital Accord and the Cyclical Behaviour of Bank Capital," Working Papers 04-30, Bank of Canada.
  2. 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.
  3. Peter J. Morgan & Mario Lamberte, 2012. "Strengthening Financial Infrastructure," Finance Working Papers 23191, East Asian Bureau of Economic Research.
  4. Mayes, David G., 2004. "Who pays for bank insolvency?," Journal of International Money and Finance, Elsevier, vol. 23(3), pages 515-551, April.
  5. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA.
  6. Llewellyn, David T. & Mayes , David G., 2003. "The role of market discipline in handling problem banks," Research Discussion Papers 21/2003, Bank of Finland.
  7. Jokivuolle, Esa & Virolainen, Kimmo & Vähämaa, Oskari, 2008. "Macro-model-based stress testing of Basel II capital requirements," Research Discussion Papers 17/2008, Bank of Finland.
  8. Hege, Ulrich & Feess, Eberhard, 2007. "Basel II and the Value of Bank Differentiation," Les Cahiers de Recherche 879, HEC Paris.
  9. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA.

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