Integrated models of capital adequacy - Why banks are undercapitalised

Gavin Kretzschmar, Alexander J. McNeil and Axel Kirchner

Journal of Banking & Finance, 2010, vol. 34, issue 12, 2838-2850

Abstract: 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.

Keywords: Risk; management; Economic; capital; Enterprise; risk; management; Basel; II; Solvency; II; Stochastic; models; Stress; testing (search for similar items in EconPapers)
Date: 2010
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Citations: View citations in EconPapers (23)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:34:y:2010:i:12:p:2838-2850

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