Internal Models, Subordinated Debt, and Regulatory Capital Requirements for Bank Credit Risk
30 Pages Posted: 1 Feb 2006
Date Written: September 2002
Abstract
Shortcomings make credit VaR estimates an unsuitable basis for setting bank regulatory capital requirements. If, alternatively, banks are required to issue subordinated debt that has a minimum market value and maximum acceptable probability of default, banks must set their equity capital in a manner that limits both the probability of bank default and the expected loss on insured deposits, largely removing any safety net-related funding cost subsidy and the moral hazard incentives it creates. Required equity capital can be estimated using a modified credit-VaR framework, and supervisors can use external credit ratings to indirectly verify the accuracy of bank internal model estimates.
Keywords: regulatory capital requirements, credit VaR, subordinated debt, internal risk models
JEL Classification: G18, G20, G21, G28
Suggested Citation: Suggested Citation
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