Integrated models of capital adequacy - Why banks are undercapitalised

Gavin Kretzschmar*, Alexander J. McNeil, Axel Kirchner

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review


With the majority of large UK and many US banks collapsing or being forced to raise capital over the 2007-9 period, blaming bankers may be satisfying but is patently insufficient; Basel II and Federal oversight frameworks also deserve criticism. We propose that the current methodological void at the heart of Basel II, Pillar 2 is filled with the recommendation that banks develop fully-integrated models for economic capital that relate asset values to fundamental drivers of risk in the economy to capture systematic effects and inter-asset dependencies in a way that crude correlation assumptions do not. We implement a fully-integrated risk analysis based on the balance sheet of a composite European bank using an economic-scenario generation model calibrated to conditions at the end of 2007. Our results suggest that the more modular, correlation-based approaches to economic capital that currently dominate practice could have led to an undercapitalisation of banks, a result that is clearly of interest given subsequent events. The introduction of integrated economic-scenario-based models in future can improve capital adequacy, enhance Pillar 2's application and rejuvenate the relevance of the Basel regulatory framework.

Original languageEnglish
Pages (from-to)2838-2850
Number of pages13
JournalJournal of Banking and Finance
Issue number12
Publication statusPublished - Dec 2010


  • Basel II
  • Economic capital
  • Enterprise risk management
  • Risk management
  • Solvency II
  • Stochastic models
  • Stress testing

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