FDIC Center for Financial Research Working Paper No. 2004-02
Paul H. Kupiec September 2004
Using a one common factor Black-Scholes-Merton model, this paper compares unbiased portfolio-invariant capital allocations with Basel II IRB capital allocations for corporate exposures. The analysis identifies substantial biases in the June 2004 IRB framework. For a wide range of portfolio credit risk characteristics considered, the Advanced IRB rules drastically undercapitalize portfolio credit risks. Implied default rates under the Advanced IRB rule exceed 5 percent. In contrast, Foundation IRB capital requirements allocate multiple times the capital necessary to ensure the supervisory target solvency rate of 99.9 percent. The biases that are identified raise a number of important issues including the potential for increased systemic risk as regulatory capital rules promote consolidation in weakly capitalized Advanced IRB banks.
Key words: economic capital, credit risk, Basel II, internal models
JEL Classification: G12, G20, G21, G28
CFR research programs: risk measurement, bank regulatory policy
FDIC Center for Financial Research Working Paper No. 2004-03
Mark J. Flannery
Kasturi P. Rangan
Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced the bank counterparties’ incentive to monitor and price default risk. We find no evidence that a bank holding company’s market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk. Our estimates indicate that most of the bank capital buildup over the sample period can be explained by greater bank risk exposures and the market's increased demand that large banks’ default risk be priced.
Key words: bank capital, bank risk, market discipline
JEL Classification: G18, G14
CFR research programs: bank regulatory policy, risk measurement