An Analysis of Off-Site Supervision of Banks' Profitability, Risk and Capital Adequacy: a portfolio simulation approach applied to brazilian banks

Theodore Barnhill, Marcos Souto and Benjamin Tabak

No 117, Working Papers Series from Central Bank of Brazil, Research Department

Abstract: In most countries, the role of off-site bank supervision involves continuous monitoring of profitability, risk and capital adequacy. The objective of this article is to demonstrate the value of bringing together advanced modeling techniques with data on banks' assets and liabilities and credit worthiness. More specifically, we apply an integrated market and credit risk simulation methodology to a group of six hypothetical banks. We show the capacity of the methodology: (i) to simulate credit transition probabilities of default close to the historical values estimated by the Central Bank of Brazil; and (ii) to simulate asset and equity returns that are unbiased estimators of average historical returns and standard deviations. Our results also indicate that: (i) a sharp reduction in the interest rate spreads of Brazilian banks reduces bank profitability and increases the probability of default; and (ii) most banks have low probability of bankruptcy. Our position is that utilization of forward looking risk evaluation methodologies in databases, such as those developed by the Central Bank of Brazil, has significant potential as an instrument of indirect supervision to identify potential risks before they materialize.

Date: 2006-09
New Economics Papers: this item is included in nep-ban, nep-cmp and nep-rmg
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Citations: View citations in EconPapers (8)

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