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Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules

Vincenzo Russo (), Valentina Lagasio (), Marina Brogi () and Frank J. Fabozzi ()
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Vincenzo Russo: Assicurazioni Generali S.p.A.
Marina Brogi: University of Rome “La Sapienza”
Frank J. Fabozzi: EDHEC Business School

Annals of Finance, 2020, vol. 16, issue 1, No 5, 157 pages

Abstract: Abstract In this paper, we estimate the probability of a financial institution breaching the Common Equity Tier 1 capital under Basel III rules. We do so by applying the Merton model, where balance sheet data and market data are used to match the probability of default implied by the model with the probability of default implied by market quotations for credit default swaps. We provide an empirical analysis for several banks classified by the Financial Stability Board and the Basel Committee on Banking Supervision as Global Systemically Important Financial Institutions, evaluating how the probability of breaching the Common Equity Tier 1 Capital evolved from 2005 to 2015. We find that higher Common Equity Tier 1 Capital ratios do not necessarily imply lower probabilities of breaching capital requirements and vice versa. We also focus on the asset volatility calibrated according to our model and we find that it appears to be a good proxy for the risk-weighted asset density.

Keywords: Probability of breaching; Basel III rules; Merton model; Credit default swap; Global Systemically Important Financial Institutions (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1007/s10436-020-00358-0

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