TY - JOUR
T1 - Integrated models of capital adequacy - Why banks are undercapitalised
AU - Kretzschmar, Gavin
AU - McNeil, Alexander J.
AU - Kirchner, Axel
PY - 2010/12
Y1 - 2010/12
N2 - 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.
AB - 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.
KW - Basel II
KW - Economic capital
KW - Enterprise risk management
KW - Risk management
KW - Solvency II
KW - Stochastic models
KW - Stress testing
UR - http://www.scopus.com/inward/record.url?scp=77956919242&partnerID=8YFLogxK
U2 - 10.1016/j.jbankfin.2010.02.028
DO - 10.1016/j.jbankfin.2010.02.028
M3 - Article
AN - SCOPUS:77956919242
SN - 0378-4266
VL - 34
SP - 2838
EP - 2850
JO - Journal of Banking & Finance
JF - Journal of Banking & Finance
IS - 12
ER -