Rating targeting and dynamic economic capital

Esa Jokivuolle and Samu Peura

Journal of Risk

Abstract: ASBTRACT The standard one-period economic capital model for credit risk has been shown to fall short of explaining the capital levels of large banks, given the usual AA confidence level for banks' solvency. Missing risk factors have been the commonly accepted explanation for this puzzle. We study an alternative explanation that complements the missing risk factor theory; a more dynamic capitalization model motivated by banks' rating targeting behavior, as evidenced in Jackson et al (2002), among others. Our model can be seen as a bottom-up alternative to Nocco and Stulz (2006)'s approach to the modeling of rating targeting. In the light of empirical evidence our model better calibrates to actual bank capital levels than the standard one-period economic capital model.

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