Research Discussion Papers, Bank of Finland
No 25/2013:
99.9% – really?
Ilkka Kiema ()
and Esa Jokivuolle ()
Abstract: The aim of the Internal Ratings Based Approach (IRBA) of
Basel II was that capital suffices for unexpected losses with at least a
99.9% probability. However, because only a fraction of the required
regulatory capital (a quarter to a half) had to be loss absorbing capital,
the actual solvency probabilities may have been much lower, as the global
financial crisis illustrates. Our estimates suggest that under Basel II
IRBA the loss-absorbing capital of an average-quality portfolio bank
suffices for unexpected losses with a 95%-99% probability. This translates
into an expected bank failure rate as high as once in twenty years. Even if
the bank's interest income is incorporated into our model, the expected
failure rate is still substantial. We show that the expected failure rate
increases with loan portfolio riskiness. Our calculations may be viewed as
a measure of regulatory "self-delusion" included in Basel II capital
requirements.
Keywords: capital requirements; IRBA; Basel II; financial crisis; (follow links to similar papers)
JEL-Codes: G21; G28; (follow links to similar papers)
42 pages, October 9, 2013
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