A cost-benefit analysis of capital requirements adjusted for model risk |
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| Institution: | 1. University of Zurich, Department of Banking and Finance, Plattenstrasse 14, 8032 Zurich, Switzerland;2. ETH Zurich, Department of Mathematics, Rämistrasse 101, 8092 Zurich, Switzerland, Zurich, Switzerland;3. Swiss Finance Institute, Zurich, Switzerland;4. Queen Mary University of London and CEPR, Mile End Road, London E1 4NS, UK;5. Bucharest University of Economic Studies, Department of Money and Banking, Bucharest, Romania |
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| 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. |
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