A Cost-Benefit Analysis of Capital Requirements Adjusted for Model Risk

44 Pages Posted: 13 Oct 2020 Last revised: 16 Oct 2020

See all articles by Walter Farkas

Walter Farkas

University of Zurich - Department of Banking and Finance; Swiss Finance Institute; ETH Zürich

Fulvia Fringuellotti

Federal Reserve Banks - Federal Reserve Bank of New York

Radu Tunaru

University of Sussex

Date Written: October 5, 2020

Abstract

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

Farkas, Walter and Fringuellotti, Fulvia and Tunaru, Radu, A Cost-Benefit Analysis of Capital Requirements Adjusted for Model Risk (October 5, 2020). Swiss Finance Institute Research Paper No. 20-86, Journal of Corporate Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3705362 or http://dx.doi.org/10.2139/ssrn.3705362

Walter Farkas (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland
+41-44-634 3953 (Phone)
+41-44-634 4345 (Fax)

HOME PAGE: http://https://people.math.ethz.ch/~farkas/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

ETH Zürich ( email )

Rämistrasse 101
ZUE F7
Zürich, 8092
Switzerland

Fulvia Fringuellotti

Federal Reserve Banks - Federal Reserve Bank of New York

33 Liberty Street
New York, NY 10045
United States

Radu Tunaru

University of Sussex ( email )

Jubilee
Brighton, BN1 9SL
United Kingdom

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