Extending the Basel II Approach to Estimate Capital Requirements for Equity Investments

28 Pages Posted: 4 Feb 2009 Last revised: 6 Feb 2009

See all articles by Mark Johnston

Mark Johnston

University of New South Wales (UNSW)

Date Written: February 3, 2009


Under the Basel II banking regulatory capital regime the capital requirements for credit exposures are calculated using the Asymptotic Single Risk Factor (ASRF) approach. The capital requirement is taken to be the contribution of an exposure to the unexpected loss on the bank's diversified portfolio.

Here we extend this approach to calculate capital requirements for equity investments. We show that in the case when asset values have a normal distribution an analytical formula for the unexpected loss contribution may be developed. We show that the capital requirements for equity investments are quite different to those of credit exposures, since equity investments can suffer substantial loss of value even when the underlying company has not defaulted.

Unexpected loss is commonly used as a measure of capital requirements, but it ignores the ability of earnings to absorb loss. We propose a definition of capital requirement that recognises the expected earnings on assets, and show how to combine the ASRF model and the Capital Asset Pricing Model to compute this quantity for credit and equity exposures.

Keywords: Capital allocation, Economic capital, Equity, Basel II, ASRF, Factor model, CAPM

JEL Classification: G21, G32

Suggested Citation

Johnston, Mark, Extending the Basel II Approach to Estimate Capital Requirements for Equity Investments (February 3, 2009). UNSW Australian School of Business Research Paper No. 2009ACTL01, Available at SSRN: https://ssrn.com/abstract=1337270 or http://dx.doi.org/10.2139/ssrn.1337270

Mark Johnston (Contact Author)

University of New South Wales (UNSW)

High St
Sydney, NSW 2052