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Simulation-based stress testing of banks’ regulatory capital adequacy

  • Samu Peura

    (Sampo plc, Finland)

  • Esa Jokivuolle

    (Helsinki School of Economics, Department of Accounting & Finance)

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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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
Note: Type of Document - pdf
Contact details of provider: Web page: http://128.118.178.162

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  1. 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.
  2. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios Tsomocos, 2005. "Procyclicality and the new Basel Accord - banks’ choice of loan rating system," Economic Theory, Springer, vol. 26(3), pages 537-557, October.
  3. 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.
  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. 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.
  6. 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.
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