Applying the Pre-Commitment Approach to bottom-up stress tests: A new old story

Simone Casellina, Giuseppe Pandolfo and Mario Quagliariello

Journal of Economics and Business, 2020, vol. 112, issue C, No S0148619520300965

Abstract: The Pre-Commitment Approach (PCA) to capital requirements was developed and promoted by the US Federal Reserve in the 1990s. The proposal was conceived as an alternative to the market-risk capital requirements based on internal models then under discussion, and eventually adopted, by the Basel Committee. Notwithstanding the Fed continued to support the PCA, the idea was abandoned, probably because it was considered too optimistic to allow banks determine the level of capital. In this paper, we study the possibility to adapt the PCA as to work as a complementary (and not alternative) tool applied to the banking book Prudential Regulation. In particular, we explore the application of this approach to a well-known issue in the context of the Stress tests: the top-down vs bottom-up debate. We focus on bottom-up stress tests and suggest creating a system of monetary penalties (charges) proportional to the difference between the expected and the realised losses of a portfolio. The charges would aim to induce model developers to reveal their best forecasts. We show that this approach can be seen as an adaptation of the pre-commitment approach (PCA) but also as an application of the penalty criterion proposed by the Italian mathematician de Finetti as the foundation of the subjectivist definition of probability. We explain how the PCA could be adapted to bottom-up stress testing and provide a practical example of the application of our proposal to the banking book. What emerges is that the PCA can indeed mitigate banks’ incentives to provide underestimated measures of risk under the adverse scenario and thus better align the incentives of banks and supervisors.

Keywords: de Finetti penality criterion; Principal-agent problem; Pre-Commitment Approach; Stress test; Banking supervision (search for similar items in EconPapers)
JEL-codes: C11 G21 G28 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0148619520300965
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jebusi:v:112:y:2020:i:c:s0148619520300965

DOI: 10.1016/j.jeconbus.2020.105931

Access Statistics for this article

Journal of Economics and Business is currently edited by Emanuele Bajo and Moritz Ritter

More articles in Journal of Economics and Business from Elsevier
Bibliographic data for series maintained by Catherine Liu ().