Research Discussion Papers, Bank of Finland
No 4/2003:
Simulation-based stress testing of banks’ regulatory capital adequacy
Samu Peura and Esa Jokivuolle ()
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.
Keywords: Basel II; Pillar 2; bank capital; stress tests; procyclicality; (follow links to similar papers)
JEL-Codes: G21; G32; (follow links to similar papers)
44 pages, February 27, 2003
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