Twin Defaults and Bank Capital Requirements

78 Pages Posted: 26 May 2020 Last revised: 18 Nov 2021

See all articles by Caterina Mendicino

Caterina Mendicino

European Central Bank (ECB) - Directorate General Research

Kalin Nikolov

European Central Bank (ECB)

Dominik Supera

University of Pennsylvania - The Wharton School

Juan-Rubio Ramirez

affiliation not provided to SSRN

Multiple version iconThere are 3 versions of this paper

Date Written: May, 2020

Abstract

We examine optimal capital requirements in a quantitative general equilibrium model with banks exposed to non-diversifiable borrower default risk. Contrary to standard models of bank default risk, our framework captures the limited upside but significant downside risk of loan portfolio returns (Nagel and Purnanandam, 2020). This helps to reproduce the frequency and severity of twin defaults: simultaneously high firm and bank failures. Hence, the optimal bank capital requirement, which trades off a lower frequency of twin defaults against restricting credit provision, is 5pp higher than under standard default risk models which underestimate the impact of borrower default on bank solvency.

JEL Classification: G01, G28, E44

Suggested Citation

Mendicino, Caterina and Nikolov, Kalin and Supera, Dominik and Ramirez, Juan-Rubio, Twin Defaults and Bank Capital Requirements (May, 2020). ECB Working Paper No. 20202414, Available at SSRN: https://ssrn.com/abstract=3609868 or http://dx.doi.org/10.2139/ssrn.3609868

Caterina Mendicino (Contact Author)

European Central Bank (ECB) - Directorate General Research ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany

Kalin Nikolov

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Dominik Supera

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Juan-Rubio Ramirez

affiliation not provided to SSRN

No Address Available

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