Research Discussion Papers, Bank of Finland
No 17/2008:
Macro-model-based stress testing of Basel II capital requirements
Esa Jokivuolle ()
, Kimmo Virolainen ()
and Oskari Vähämaa ()
Abstract: Basel II framework requires banks to conduct stress tests
on their potential future minimum capital requirements and consider ‘at
least the effect of mild recession scenarios’. We propose a stress testing
framework for minimum capital requirements in which banks’ corporate credit
risks are modeled with macroeconomic variables. We can thus define
scenarios such as a mild recession and consider the resulting credit risk
developments and consequent changes in minimum capital requirements. We
also emphasize the importance of stress testing future minimum capital
requirements jointly with credit losses. Our illustrative results based on
Finnish data underline the importance of such joint modeling. We also find
that stress tests based on scenarios envisaged by regulators are not likely
to imply binding capital constraints on banks.
Keywords: Basel II; capital requirements; credit risk; loan losses; stress tests; (follow links to similar papers)
JEL-Codes: C15; G21; G28; G33; (follow links to similar papers)
27 pages, September 2, 2008
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