Adequacy of Existing Level of Capital Implied by the Basel Standards Relative to the Credit Risk Exposures of Banks in the SEACEN Region

This collaborative research project aims to measure the level of riska in the banking system using available supervisory information with the view to determine whether the existing levels of capital is commensurate to the level of risks implied by them. This supervisory information includes data on loan accounts that are either past due or current as classified by the supervisors and the provision set aside for these loans. The study finds that simulating the credit loss distribution using the data on loan loss provision and estimating the Value-at-Risk (VaR) as the upper limit of the distribution would result to measures of capital (derived as the residual of the VaR value and the sum of provision for past due accounts) that underestimates the capital as implied by either the Capital Adequacy Ration (CAR) or by the risk-based capital for loan portfolio alone. On the other hand, simulating the distribution of credit losses using the actual loss given default rate on defaulted accounts and estimating VaR and consequently, the capital for unexpected losses from this distribution would result to capital larger than that implied by the risk- based capital for loan portfolio alone. The same trend is observed when comparison is made between VaR and the sum of capital implied by CAR and the specific provision. The study made use of bootstrapping technique in simulating the credit loss distribution with the STATA software facilitating the process. The lack of historical data for most SEACEN countries delimited the study to using stock data in its estimation. The study recommends that for robust estimation of capital, the procedure must be used for data that reflects or takes account of the economic cycle. It also recommends that a more complete data be gathered to facilitate comparision with model-based methodologies for credit risk measurement and to take account of the risk accounted for by risk assets other than the loan portfolio of the bank.