Measuring and Stress-Testing Market-Implied Bank Capital
55 Pages Posted: 28 Aug 2021 Last revised: 26 Jan 2022
Date Written: August 26, 2021
We propose a methodology for measuring the market-implied capital of banks by subtracting from the market value of equity (market capitalization) a credit-spread-based correction for the value of shareholders' default option. We show that without such a correction, the estimated impact of a severe market downturn is systematically distorted, underestimating the risk of banks with low market capitalization. We argue that this adjusted measure of capital is the relevant market-implied capital measure for policymakers. We propose an econometric model for the combined simulation of equity prices and CDS spreads, which allows us to introduce this correction in the SRISK framework for measuring systemic risk.
Keywords: Banking, Capital, Stress Test, Systemic Risk, Multifactor Model
JEL Classification: C32, G01, G21, G28, G32
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