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Risk-Based Capital Standards, Deposit Insurance and Procyclicality - PDF 617k (PDF Help)

FDIC Center for Financial Research Working Paper No. 2004-05
George G. Pennacchi
November 2004

Abstract
This article shows that risk-based deposit insurance premiums generate smaller procyclical effects than do risk-based capital requirements. Thus, Basel II’s procyclical impact can be reduced by integrating risk-based deposit insurance. If deposit insurance is structured as a moving average of contracts, its procyclical effects can be decreased further. Empirical illustrations of this are presented for 42 banks over the period 1987 to 1996. The results confirm that lengthening the contracts’ maturities intertemporally smoothes premiums but raises the average premium level needed to compensate the insurer for greater systematic risk. The distribution of risk-based premiums across banks is skewed.

Key Words: capital standards, deposit insurance, procyclical

JEL Classification: G21; G22; G28

CFR Research Programs: deposit insurance, bank regulatory policy.

FDIC Center for Financial Research Working Paper No. 2004-04
Sanjiv R. Das
Darrell Duffie
Nikunj Kapadia
September 2004

Abstract
We develop, and apply to data on U.S. corporations from 1987-2000, tests of the standard doubly-stochastic assumption under which firms’ default times are correlated only as implied by correlation of their default intensity processes, for example through dependence on common or correlated observable risk factors. Our tests do not require assumptions on the correlation structure of default intensities. The data do not support the joint hypothesis of well specified default intensities and the doubly stochastic assumption, although we provide evidence that this may be due to mis-specification of the default intensities, which do not include macroeconomic default-prediction covariates. Despite this rejection, there is at most weak evidence of default clustering in excess of that implied by the doubly-stochastic model and correlation of the firm-specific default covariates.

Key words: bank capital, bank risk, market discipline

JEL Classification: G18, G14

CFR research programs: bank regulatory policy, risk measurement

FDIC Center for Financial Research Working Paper No. 2004-03
Mark J. Flannery
Kasturi P. Rangan
August 2004

Abstract
Large U.S. banks dramatically increased their capitalization during the 1990s, to the highest levels in more than 50 years. We document this buildup of capital and evaluate several potential motivations. Our results support the hypothesis that regulatory innovations in the early 1990s weakened conjectural government guarantees and enhanced the bank counterparties’ incentive to monitor and price default risk. We find no evidence that a bank holding company’s market capitalization increases with its asset volatility prior to 1994. Thereafter, the data display a strong cross-sectional relation between capitalization and asset risk. Our estimates indicate that most of the bank capital buildup over the sample period can be explained by greater bank risk exposures and the market's increased demand that large banks’ default risk be priced.

Key words: bank capital, bank risk, market discipline

JEL Classification: G18, G14

CFR research programs: bank regulatory policy, risk measurement

Abstract
Using a one common factor Black-Scholes-Merton (BSM) equilibrium model of credit risk, this paper derives unbiased capital allocation rules for portfolios in which idiosyncratic risk is fully diversified. When these rules are compared with the Basel II Internal Ratings Based (IRB) minimum capital requirements for corporate exposures, the comparison shows that the Basel Advanced IRB (A-IRB) approach drastically undercapitalizes portfolio credit risk relative to the supervisory target of a 99.9 percent bank solvency rate. Estimates show that Basel regulations will allow fully compliant A-IRB banks to have default rates that exceed 5 percent. In contrast, the Foundation IRB minimum capital requirements allocate multiple times the capital necessary to achieve the supervisory objective. These results raise a number of important issues including the potential for increased systemic risk as regulatory capital rules promote banking sector consolidation and poor risk management standards in A-IRB banks.

Key words: economic capital, credit risk, Basel II, internal models

JEL Classification: G12, G20, G21, G28

CFR research programs: risk measurement, bank regulatory policy

Abstract
This paper proposes methods for obtaining risk neutral distributions when only the statistical density is observed. We employ renormalized exponential tilts and estimate the tilt coefficients from related options markets. Particular emphasis is placed on reinsurance losses for which we price in closed form using the Weibull extreme value distribution. The procedure is illustrated in detail for FDIC losses.

CFR research programs: risk measurement, deposit insurance