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Measuring bank capital requirements through Dynamic Factor analysis

Author

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  • Andrea Cipollini

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  • Giuseppe Missaglia

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Abstract

In this paper, using industry sector stock returns as proxies of firm asset values, we obtain bank capital requirements (through the cycle). This is achieved by Montecarlo simulation of a bank loan portfolio loss density. We depart from the Basel 2 analytical formula developed by Gordy (2003) for the computation of the economic capital by, first, allowing dynamic heterogeneity in the factor loadings, and, also, by accounting for stochastic dependent recoveries. Dynamic heterogeneity in the factor loadings is introduced by using dynamic forecast of a Dynamic Factor model fitted to a large dataset of macroeconomic credit drivers. The empirical findings show that there is a decrease in the degree of Portfolio Credit Risk, once we move from the Basel 2 analytic formula to the Dynamic Factor model specification.

Suggested Citation

  • Andrea Cipollini & Giuseppe Missaglia, 2008. "Measuring bank capital requirements through Dynamic Factor analysis," Center for Economic Research (RECent) 010, University of Modena and Reggio E., Dept. of Economics "Marco Biagi".
  • Handle: RePEc:mod:recent:010
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    References listed on IDEAS

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    1. Pesaran, M. Hashem & Schuermann, Til & Treutler, Bjorn-Jakob & Weiner, Scott M., 2006. "Macroeconomic Dynamics and Credit Risk: A Global Perspective," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(5), pages 1211-1261, August.
    2. Jushan Bai & Serena Ng, 2002. "Determining the Number of Factors in Approximate Factor Models," Econometrica, Econometric Society, vol. 70(1), pages 191-221, January.
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Bruche, Max & González-Aguado, Carlos, 2010. "Recovery rates, default probabilities, and the credit cycle," Journal of Banking & Finance, Elsevier, vol. 34(4), pages 754-764, April.
    5. Edward I. Altman & Brooks Brady & Andrea Resti & Andrea Sironi, 2005. "The Link between Default and Recovery Rates: Theory, Empirical Evidence, and Implications," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2203-2228, November.
    6. Philipp J. Schönbucher, 2000. "Factor Models for Portofolio Credit Risk," Bonn Econ Discussion Papers bgse16_2001, University of Bonn, Germany.
    7. Acharya, Viral V. & Bharath, Sreedhar T. & Srinivasan, Anand, 2007. "Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries," Journal of Financial Economics, Elsevier, vol. 85(3), pages 787-821, September.
    8. Hanson, Samuel G. & Pesaran, M. Hashem & Schuermann, Til, 2008. "Firm heterogeneity and credit risk diversification," Journal of Empirical Finance, Elsevier, vol. 15(4), pages 583-612, September.
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    Cited by:

    1. Petr Gapko & Martin Smid, 2012. "Dynamic Multi-Factor Credit Risk Model with Fat-Tailed Factors," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 62(2), pages 125-140, May.

    More about this item

    Keywords

    Dynamic Factor Model; Forecasting; Stochastic Simulation; Risk Management; Banking;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • E17 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Forecasting and Simulation: Models and Applications
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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