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A cost-benefit analysis of capital requirements adjusted for model risk

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  • Farkas, Walter
  • Fringuellotti, Fulvia
  • Tunaru, Radu

Abstract

Capital adequacy is the key microprudential and macroprudential tool of banking regulation. Financial models of capital adequacy are subject to errors, which may prevent from estimating a sufficient capital base to absorb bank losses during economic downturns. In this paper, we propose a general method to account for model risk in capital requirements calculus related to market risk. We then evaluate and compare our capital requirements values with those obtained under Basel 2.5 and the new Basel 4 regulation. Capital requirements adjusted for model risk perform well in containing losses generates in normal and stressed times. In addition, they are as conservative as Basel 4 capital requirements, but they exhibit less fluctuations over time.

Suggested Citation

  • Farkas, Walter & Fringuellotti, Fulvia & Tunaru, Radu, 2020. "A cost-benefit analysis of capital requirements adjusted for model risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
  • Handle: RePEc:eee:corfin:v:65:y:2020:i:c:s0929119920301978
    DOI: 10.1016/j.jcorpfin.2020.101753
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    More about this item

    Keywords

    Basel framework; Capital requirements; Cost-benefit analysis; Model risk;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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