Macro-Model-Based Stress Testing of Basel II Capital Requirements

30 Pages Posted: 16 Sep 2008

See all articles by Esa Jokivuolle

Esa Jokivuolle

Bank of Finland, Research Unit

Kimmo Virolainen

Bank of Finland

Oskari Vähämaa

Bank of Finland - Research; University of Turku

Date Written: September, 12 2008

Abstract

Basel II framework requires banks to conduct stress tests on their potential future minimum capital requirements and consider 'at least the effect of mild recession scenarios'. We propose a stress testing framework for minimum capital requirements in which banks' corporate credit risks are modeled with macroeconomic variables. We can thus define scenarios such as a mild recession and consider the resulting credit risk developments and consequent changes in minimum capital requirements. We also emphasize the importance of stress testing future minimum capital requirements jointly with credit losses. Our illustrative results based on Finnish data underline the importance of such joint modeling. We also find that stress tests based on scenarios envisaged by regulators are not likely to imply binding capital constraints on banks.

Keywords: Basel II, capital requirements, credit risk, loan losses, stress tests

JEL Classification: C15, G21, G28, G33

Suggested Citation

Jokivuolle, Esa and Virolainen, Kimmo and Vähämaa, Oskari and Vähämaa, Oskari, Macro-Model-Based Stress Testing of Basel II Capital Requirements (September, 12 2008). Bank of Finland Research Discussion Paper No. 17/2008, Available at SSRN: https://ssrn.com/abstract=1267194 or http://dx.doi.org/10.2139/ssrn.1267194

Esa Jokivuolle (Contact Author)

Bank of Finland, Research Unit ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland
+358 10 831 2309 (Phone)

HOME PAGE: http://www.bof.fi/en/suomen_pankki/organisaatio/asiantuntijoita/jokivuolle_esa/

Kimmo Virolainen

Bank of Finland ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

Oskari Vähämaa

Bank of Finland - Research ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

University of Turku ( email )

Turku, 20014
Finland

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