Stress Testing Credit Risk: The Great Depression Scenario
Simone Varotto (s.varotto@icmacentre.ac.uk)
ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading
Abstract:
By using Moody's historical corporate default histories we explore the implications of scenarios based on the Great Depression for banks' economic capital and for existing and proposed regulatory capital requirements. By assuming different degrees of portfolio illiquidity, we then investigate the relationship between liquidity and credit risk and employ our findings to estimate the Incremental Risk Charge (IRC), the new credit risk capital add-on introduced by the Basel Committee for the trading book. Finally, we compare our IRC estimates with stressed market risk measures derived from a sample of corporate bond indices encompassing the recent financial crisis. This allows us to determine the extent to which trading book capital would change in stress conditions under newly proposed rules. We find that, typically, banking book regulation leads to minimum capital levels that would enable banks to withstand Great Depression-like events, except when their portfolios have long average maturity. We also show that although the IRC in the trading book may be considerable, the capital needed to absorb market risk related losses in stressed scenarios can be more than twenty times larger.
Keywords: Credit Risk; Financial Crisis; Economic Capital; Basel II; Liquidity Risk (search for similar items in EconPapers)
JEL-codes: G11 G21 G22 G28 G32 (search for similar items in EconPapers)
Pages: 51 pages
Date: 2010-03
New Economics Papers: this item is included in nep-ban, nep-fmk, nep-his, nep-reg and nep-rmg
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Journal Article: Stress testing credit risk: The Great Depression scenario (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:rdg:icmadp:icma-dp2010-03
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