Determining the fair level of economic capital for credit and market risk in commercial banks

Abstract

Banks play a strategically important role in the machinations of both global finance and the global economy. Ensuring the stability and good governance of the banking milieu falls within the ambit of the Bank for International Settlements (BIS) which recognised the importance of banks and established the Basel Committee on Banking Supervision (BCBS) in 1974. The BCBS has engineered and distributed two accords? Basel I and Basel II? over the last two decades since 1988 with the goal of promoting adequately and appropriately regulated banks. The latest of these? Basel II? embraces three risk components namely market, credit and operational risk. The most significant aspect of the current (Basel II) accord is the determination of the appropriate amount of regulatory capital, i.e. an amount which is not so lenient that it allows banks to regularly fail and yet not be too onerous as to impede the day to day operations of a bank. The assessment of bank capital adequacy and the enforcement of sufficient retained capital are important functions undertaken by banking supervisors. Basel II requires that banks retain sufficient capital, at given confidence levels, to prevent insolvency. Banks must also satisfy local regulators (who may interpret and impose more stringent aspects of the accord) that additional risks have been adequately and appropriately addressed and the requisite capital has been reserved for these. The ultimate aim of the BCBS is to align banks' regulatory capital (the amount required to keep banks solvent as decided by the BCBS) with banks' internal (or economic) capital. The former is estimated via equations which are based on several economic assumptions, but are by definition highly conservative. The equations comprise several inputs, some of which are determined by banks using the most advanced approaches but many of which have been deliberately fixed by the BCBS as a means of introducing and establishing the perceived austerity into capital requirement formulas. The rationale behind the choices of fixed parameters has never been publicly released and this opacity obscures the fairness of the capital requirements; fairness in the sense of "do these fixed parameter restrictions make for capital requirements that are too onerous or too lenient?" Without details of how to estimate these fixed parameters, banks using the BCBS-specified equations must simply accept that the requirements are "fair" or at least appropriate. This thesis establishes measurement methodologies of the opaque, fixed variables of Basel II?s capital equations using banks' own empirical data. Using these methodologies, banks (of any size and complexity) may determine their own unique parameters from their own internal loss experience and thus assess the fairness of the imposed regulatory capital charges. If these are deemed too lenient, banks can increase their capital reserves and if too onerous, banks can adjust the pricing of risky securities. In either case, banks using these methodologies will be able to establish precisely their unique, empirical capital requirements without blind acceptance of obscured parameters in the capital calculations of Basel II.