A Cost-Benefit Analysis of Capital Requirements Adjusted for Model Risk
44 Pages Posted: 13 Oct 2020 Last revised: 16 Oct 2020
Date Written: October 5, 2020
Capital adequacy is the key microprudential and macroprudential tool of banking regulation. Financial models of capital adequacy are subject to errors, which may prevent from estimating a sufficient capital base to absorb bank losses during economic downturns. In this paper, we propose a general method to account for model risk in capital requirements calculus related to market risk. We then evaluate and compare our capital requirements values with those obtained under Basel 2.5 and the new Basel 4 regulation. Capital requirements adjusted for model risk perform well in containing losses generates in normal and stressed times. In addition, they are as conservative as Basel 4 capital requirements, but they exhibit less fluctuations over time.
Keywords: Basel framework, capital requirements, cost-benefit analysis, model risk
JEL Classification: D81, G17, G18
Suggested Citation: Suggested Citation