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A cost-benefit analysis of capital requirements adjusted for model risk

Walter Farkas, Fulvia Fringuellotti and Radu Tunaru

Journal of Corporate Finance, 2020, vol. 65, issue C

Abstract: Capital adequacy is the key microprudential and macroprudential tool of banking regulation. Financial models of capital adequacy are subject to errors, which may prevent from estimating a sufficient capital base to absorb bank losses during economic downturns. In this paper, we propose a general method to account for model risk in capital requirements calculus related to market risk. We then evaluate and compare our capital requirements values with those obtained under Basel 2.5 and the new Basel 4 regulation. Capital requirements adjusted for model risk perform well in containing losses generates in normal and stressed times. In addition, they are as conservative as Basel 4 capital requirements, but they exhibit less fluctuations over time.

Keywords: Basel framework; Capital requirements; Cost-benefit analysis; Model risk (search for similar items in EconPapers)
JEL-codes: D81 G17 G18 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:corfin:v:65:y:2020:i:c:s0929119920301978

DOI: 10.1016/j.jcorpfin.2020.101753

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