IDEAS home Printed from https://ideas.repec.org/p/wpa/wuwpfi/0405003.html
   My bibliography  Save this paper

Simulation-based stress testing of banks’ regulatory capital adequacy

Author

Listed:
  • 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.

Suggested Citation

  • Samu Peura & Esa Jokivuolle, 2004. "Simulation-based stress testing of banks’ regulatory capital adequacy," Finance 0405003, University Library of Munich, Germany.
  • Handle: RePEc:wpa:wuwpfi:0405003
    Note: Type of Document - pdf
    as

    Download full text from publisher

    File URL: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0405/0405003.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Eva Catarineu-Rabell & Patricia Jackson & Dimitrios Tsomocos, 2005. "Procyclicality and the new Basel Accord - banks’ choice of loan rating system," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 26(3), pages 537-557, October.
    2. Bhattacharya, Sudipto & Plank, Manfred & Strobl, Gunter & Zechner, Josef, 2002. "Bank capital regulation with random audits," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1301-1321, July.
    3. 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.
    4. Claudio Borio & Craig Furfine & Philip Lowe, 2001. "Procyclicality of the financial system and financial stability: issues and policy options," BIS Papers chapters, in: Bank for International Settlements (ed.), Marrying the macro- and micro-prudential dimensions of financial stability, volume 1, pages 1-57, Bank for International Settlements.
    5. Craig Furfine, 2001. "Bank Portfolio Allocation: The Impact of Capital Requirements, Regulatory Monitoring, and Economic Conditions," Journal of Financial Services Research, Springer;Western Finance Association, vol. 20(1), pages 33-56, September.
    6. Bjarne Hø Jgaard & Michael Taksar, 1999. "Controlling Risk Exposure and Dividends Payout Schemes:Insurance Company Example," Mathematical Finance, Wiley Blackwell, vol. 9(2), pages 153-182, April.
    7. 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.
    8. 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.
    9. Philip Lowe, 2002. "Credit risk measurement and procyclicality," BIS Working Papers 116, Bank for International Settlements.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Mark Illing & Graydon Paulin, 2004. "The New Basel Capital Accord and the Cyclical Behaviour of Bank Capital," Staff Working Papers 04-30, Bank of Canada.
    2. Kauko, Karlo, 2007. "Interlinking securities settlement systems: A strategic commitment?," Journal of Banking & Finance, Elsevier, vol. 31(10), pages 2962-2977, October.
    3. Llewellyn, David T. & Mayes, David G., 2003. "The role of market discipline in handling problem banks," Research Discussion Papers 21/2003, Bank of Finland.
    4. Morgan, Peter J. & Lamberte , Mario, 2012. "Strengthening Financial Infrastructure," ADBI Working Papers 345, Asian Development Bank Institute.
    5. repec:zbw:bofrdp:2008_017 is not listed on IDEAS
    6. repec:zbw:bofrdp:2003_028 is not listed on IDEAS
    7. repec:zbw:bofrdp:2003_014 is not listed on IDEAS
    8. repec:zbw:bofrdp:2003_021 is not listed on IDEAS
    9. Jokivuolle, Esa & Virolainen, Kimmo & Vähämaa, Oskari, 2008. "Macro-model-based stress testing of Basel II requirements," Research Discussion Papers 17/2008, Bank of Finland.
    10. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, University Library of Munich, Germany.
    11. Vauhkonen, Jukka, 2003. "Banks' equity stakes in borrowing firms : A corporate finance approach," Research Discussion Papers 13/2003, Bank of Finland.
    12. Llewellyn, David T. & Mayes, David G., 2003. "The role of market discipline in handling problem banks," Bank of Finland Research Discussion Papers 21/2003, Bank of Finland.
    13. David G. Mayes & Aarno Liuksila & Thorsten Beck & Bethany Blowers & Henk Brouwer & Peik Granlund & Christos Hadjiemmanuil & Gerbert Hebbink & Eva H. G. Hüpkes & Eigil Mølgaard & Jón Sigurðsson & Gary , 2004. "Who Pays for Bank Insolvency?," Palgrave Macmillan Books, Palgrave Macmillan, number 978-0-230-52391-3, June.
    14. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, University Library of Munich, Germany.
    15. Alejandro Ferrer Pérez & José Casals Carro & Sonia Sotoca López, 2014. "Conditional coverage and its role in determining and assessing long-term capital requirements," Documentos de Trabajo del ICAE 2014-12, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico.
    16. Juliusz Jablecki, 2009. "The impact of Basel I capital requirements on bank behavior and the efficacy of monetary policy," International Journal of Business and Economic Sciences Applied Research (IJBESAR), International Hellenic University (IHU), Kavala Campus, Greece (formerly Eastern Macedonia and Thrace Institute of Technology - EMaTTech), vol. 2(1), pages 16-35, June.
    17. Hege, Ulrich & Feess, Eberhard, 2007. "Basel II and the Value of Bank Differentiation," HEC Research Papers Series 879, HEC Paris.
    18. repec:zbw:bofrdp:2003_013 is not listed on IDEAS
    19. repec:zbw:bofrdp:2003_012 is not listed on IDEAS
    20. Vauhkonen, Jukka, 2003. "Financial contracts and contingent control rights," Research Discussion Papers 14/2003, Bank of Finland.
    21. 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.
    22. Vauhkonen, Jukka, 2003. "Are adverse selection models of debt robust to changes in market structure?," Research Discussion Papers 28/2003, Bank of Finland.
    23. David G. Mayes & Peter J. Morgan, 2012. "The Global Financial Crisis and its Implications for Financial Sector Reform and Regulation in Asia," Chapters, in: Masahiro Kawai & David G. Mayes & Peter Morgan (ed.), Implications of the Global Financial Crisis for Financial Reform and Regulation in Asia, chapter 1, Edward Elgar Publishing.
    24. Guender, Alfred V., 2003. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Bank of Finland Research Discussion Papers 12/2003, Bank of Finland.
    25. repec:zbw:bofrdp:2003_026 is not listed on IDEAS

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Peura, Samu & Jokivuolle, Esa, 2003. "Simulation-based stress testing of banks' regulatory capital adequacy," Research Discussion Papers 4/2003, Bank of Finland.
    2. repec:zbw:bofrdp:2003_004 is not listed on IDEAS
    3. Peura, Samu & Jokivuolle, Esa, 2003. "Simulation-based stress testing of banks' regulatory capital adequacy," Bank of Finland Research Discussion Papers 4/2003, Bank of Finland.
    4. Peura, Samu & Jokivuolle, Esa, 2004. "Simulation based stress tests of banks' regulatory capital adequacy," Journal of Banking & Finance, Elsevier, vol. 28(8), pages 1801-1824, August.
    5. Pederzoli, Chiara & Torricelli, Costanza, 2005. "Capital requirements and business cycle regimes: Forward-looking modelling of default probabilities," Journal of Banking & Finance, Elsevier, vol. 29(12), pages 3121-3140, December.
    6. Amato, Jeffery D. & Furfine, Craig H., 2004. "Are credit ratings procyclical?," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2641-2677, November.
    7. Keppo, Jussi & Kofman, Leonard & Meng, Xu, 2010. "Unintended consequences of the market risk requirement in banking regulation," Journal of Economic Dynamics and Control, Elsevier, vol. 34(10), pages 2192-2214, October.
    8. Markus Behn & Rainer Haselmann & Paul Wachtel, 2016. "Procyclical Capital Regulation and Lending," Journal of Finance, American Finance Association, vol. 71(2), pages 919-956, April.
    9. Chiara Pederzoli & Costanza Torricelli & Dimitrios Tsomocos, 2010. "Rating systems, procyclicality and Basel II: an evaluation in a general equilibrium framework," Annals of Finance, Springer, vol. 6(1), pages 33-49, January.
    10. David Martinez-Miera & Rafael Repullo, 2019. "Monetary Policy, Macroprudential Policy, and Financial Stability," Annual Review of Economics, Annual Reviews, vol. 11(1), pages 809-832, August.
    11. Ines Drumond, 2009. "Bank Capital Requirements, Business Cycle Fluctuations And The Basel Accords: A Synthesis," Journal of Economic Surveys, Wiley Blackwell, vol. 23(5), pages 798-830, December.
    12. Fabrizio Fabi & Sebastiano Laviola & Paolo Marullo Reedtz, 2004. "The treatment of SMEs loans in the New Basel Capital Accord: some evaluations," BNL Quarterly Review, Banca Nazionale del Lavoro, vol. 57(228), pages 29-70.
    13. Akhigbe, Aigbe & Madura, Jeff & Marciniak, Marek, 2012. "Bank capital and exposure to the financial crisis," Journal of Economics and Business, Elsevier, vol. 64(5), pages 377-392.
    14. Bonfim, Diana, 2009. "Credit risk drivers: Evaluating the contribution of firm level information and of macroeconomic dynamics," Journal of Banking & Finance, Elsevier, vol. 33(2), pages 281-299, February.
    15. Michiel Bijlsma & Wim Suyker, 2008. "The credit crisis and the Dutch economy... in eight frequently asked questions," CPB Memorandum 210.rdf, CPB Netherlands Bureau for Economic Policy Analysis.
    16. Fabrizio Fabi & Sebastiano Laviola & Paolo Marullo Reedtz, 2004. "The treatment of SMEs loans in the New Basel Capital Accord: some evaluations," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 57(228), pages 29-70.
    17. Michiel Bijlsma & Jeroen Klomp & Sijmen Duineveld, 2010. "Systemic risk in the financial sector; a review and synthesis," CPB Document 210.rdf, CPB Netherlands Bureau for Economic Policy Analysis.
    18. Stolz, Stéphanie & Wedow, Michael, 2005. "Banks' regulatory capital buffer and the business cycle: evidence for German savings and cooperative banks," Discussion Paper Series 2: Banking and Financial Studies 2005,07, Deutsche Bundesbank.
    19. repec:onb:oenbwp:y:2003:i:5:b:1 is not listed on IDEAS
    20. Borio, Claudio & Zhu, Haibin, 2012. "Capital regulation, risk-taking and monetary policy: A missing link in the transmission mechanism?," Journal of Financial Stability, Elsevier, vol. 8(4), pages 236-251.
    21. Vanessa Redak & Alexander Tscherteu, 2003. "Basel II, Procyclicality and Credit Growth - First Conclusions from QIS 3," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 5, pages 56-69.
    22. Fabrizio Fabi & Sebastiano Laviola & Paolo Marullo Reedtz, 2005. "Lending decisions, procyclicality and the New Basel Capital Accord," BIS Papers chapters, in: Bank for International Settlements (ed.), Investigating the relationship between the financial and real economy, volume 22, pages 361-91, Bank for International Settlements.

    More about this item

    Keywords

    Basel II; Pillar 2; bank capital; stress tests; procyclicality;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:wpa:wuwpfi:0405003. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: EconWPA (email available below). General contact details of provider: https://econwpa.ub.uni-muenchen.de .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.