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A Cost-Benefit Analysis of Capital Requirements Adjusted for Model Risk


Farkas, W; Fringuellotti, Fulvia; Tunaru, Radu (2020). A Cost-Benefit Analysis of Capital Requirements Adjusted for Model Risk. Journal of Corporate Finance, 65:101753.

Abstract

Capital adequacy is the key microprudential and macroprudential tool of banking regulation. Financial models of capital adequacy are subject to errors, which may prevent from estimating a sufficient capital base to absorb bank losses during economic downturns. In this paper, we propose a general method to account for model risk in capital requirements calculus related to market risk. We then evaluate and compare our capital requirements values with those obtained under Basel 2.5 and the new Basel 4 regulation. Capital requirements adjusted for model risk perform well in containing losses generates in normal and stressed times. In addition, they are as conservative as Basel 4 capital requirements, but they exhibit less fluctuations over time.

Abstract

Capital adequacy is the key microprudential and macroprudential tool of banking regulation. Financial models of capital adequacy are subject to errors, which may prevent from estimating a sufficient capital base to absorb bank losses during economic downturns. In this paper, we propose a general method to account for model risk in capital requirements calculus related to market risk. We then evaluate and compare our capital requirements values with those obtained under Basel 2.5 and the new Basel 4 regulation. Capital requirements adjusted for model risk perform well in containing losses generates in normal and stressed times. In addition, they are as conservative as Basel 4 capital requirements, but they exhibit less fluctuations over time.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Scopus Subject Areas:Social Sciences & Humanities > Business and International Management
Social Sciences & Humanities > Finance
Social Sciences & Humanities > Economics and Econometrics
Social Sciences & Humanities > Strategy and Management
Language:English
Date:1 December 2020
Deposited On:16 Dec 2020 11:34
Last Modified:28 Feb 2021 08:21
Publisher:Elsevier
ISSN:0929-1199
OA Status:Closed
Free access at:Related URL. An embargo period may apply.
Publisher DOI:https://doi.org/10.1016/j.jcorpfin.2020.101753
Official URL:https://www.sciencedirect.com/science/article/pii/S0929119920301978?casa_token=XwdUBWP4o4EAAAAA:K98KLP61kyUOmMVJ5ZlIhSnsh2MXqlcGRExp1CJXOoWmlSvkTk1Rju1h9FEZOvAlE-R61UuA9k0
Related URLs:https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3705362 (Organisation)
Other Identification Number:merlin-id:19903

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