Skip to main content
Disciplines
Automotive Business IT + Informatics Construction + Real Estate Electrical Engineering + Electronics Energy + Sustainability Insurance + Risk Finance + Banking Management + Leadership Marketing + Sales Mechanical Engineering + Materials
Events
DE
EN
Books
Journals
Topic Page
Marketing
Start single access now
Access for companies
EXTENDED SEARCH
Log in
Top
Annals of Finance
Published in: Annals of Finance 1/2020

16-01-2020 | Research Article

Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules

Authors: Vincenzo Russo, Valentina Lagasio, Marina Brogi, Frank J. Fabozzi

Published in: Annals of Finance | Issue 1/2020

Log in

Activate our intelligent search to find suitable subject content or patents.

search-config
loading …

Abstract

In this paper, we estimate the probability of a financial institution breaching the Common Equity Tier 1 capital under Basel III rules. We do so by applying the Merton model, where balance sheet data and market data are used to match the probability of default implied by the model with the probability of default implied by market quotations for credit default swaps. We provide an empirical analysis for several banks classified by the Financial Stability Board and the Basel Committee on Banking Supervision as Global Systemically Important Financial Institutions, evaluating how the probability of breaching the Common Equity Tier 1 Capital evolved from 2005 to 2015. We find that higher Common Equity Tier 1 Capital ratios do not necessarily imply lower probabilities of breaching capital requirements and vice versa. We also focus on the asset volatility calibrated according to our model and we find that it appears to be a good proxy for the risk-weighted asset density.
previous article Infinitesimal generators for two-dimensional Lévy process-driven hypothesis testing

Dont have a licence yet? Then find out more about our products and how to get one now:

Springer Professional "Wirtschaft+Technik"

Online-Abonnement

Mit Springer Professional "Wirtschaft+Technik" erhalten Sie Zugriff auf:

  • über 102.000 Bücher
  • über 537 Zeitschriften

aus folgenden Fachgebieten:

  • Automobil + Motoren
  • Bauwesen + Immobilien
  • Business IT + Informatik
  • Elektrotechnik + Elektronik
  • Energie + Nachhaltigkeit
  • Finance + Banking
  • Management + Führung
  • Marketing + Vertrieb
  • Maschinenbau + Werkstoffe
  • Versicherung + Risiko

Jetzt Wissensvorsprung sichern!

inform now

Springer Professional "Wirtschaft"

Online-Abonnement

Mit Springer Professional "Wirtschaft" erhalten Sie Zugriff auf:

  • über 67.000 Bücher
  • über 340 Zeitschriften

aus folgenden Fachgebieten:

  • Bauwesen + Immobilien
  • Business IT + Informatik
  • Finance + Banking
  • Management + Führung
  • Marketing + Vertrieb
  • Versicherung + Risiko




Jetzt Wissensvorsprung sichern!

inform now
Footnotes
1
Using the discretion allowed for by the Basel II framework and specifically of the internal rating-based approach, banks calculate capital requirements that are typically lower than the requirements obtained under the standard approach. (Barucci and Milani 2018; Vallascas and Hagendorff 2013).
 
2
As specified in BCBS (2011), minimum Common Equity Tier 1 Capital “consists of the sum of the following elements: Common shares issued by the bank that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies); Stock surplus (share premium) resulting from the issue of instruments included Common Equity Tier 1; Retained earnings; Accumulated other comprehensive income and other disclosed reserves; Common shares issued by consolidated subsidiaries of the bank and held by third parties (i.e. minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital; and Regulatory adjustments applied in the calculation of Common Equity Tier 1”. For the years 2013 and 2014 the minimum ratio was 3.5% and 4.0%, respectively.
 
3
The minimum ratio according to BCBS (2011) was 8.0% in 2014, 8.625% in 2016, and 9.25% in 2017. For 2018 and 2019 this ratio is expected to be 9.875% and 10.5% respectively.
 
4
According to the BCBS (2011), regulatory capital consists of (i) Core capital (basic equity or Tier 1 Capital, which can be considered as the going-concern capital)—made of Common Equity Tier 1 and Additional Tier 1, and (ii) Supplementary capital (or Tier 2, which is the gone-concern capital). In addition to these elements, the BCBS requires: (iii) a capital conservation buffer (which is designed to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred. The requirement is based on simple capital conservation rules designed to avoid breaches of minimum capital requirements) and a (iv) countercyclical buffer that aims to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate.
 
5
The banks selected are those for which market data are available to be used as input for the proposed model.
 
6
See Black and Scholes (1973) and Merton (1974).
 
7
A widely used approach to calibrate Merton’s model has been proposed by Crosbie and Bohn (2002).
 
8
See Liberadzki and Liberadzki (2019) for further details on these topics.
 
9
We apply the standard bootstrapping technique to derive the spot rates from the traded market instruments.
 
10
CDSs with a 5-year maturity were considered for the analysis because they were the most liquid tenors.
 
Literature
Acharya, V., Engle, R., Pierret, D.: Testing macroprudential stress tests: the risk of regulatory risk weights. J Monet Econ 65, 36–53 (2014)CrossRef
Acharya, V., Steffen, S.: The “greatest” carry trade ever? Understanding Eurozone bank risks. J Financ Econ 115, 215–236 (2015)CrossRef
Alexander, G.J., Alexandre, M.B., Shu, Y.: Bank regulation and international financial stability: a case against the 2006 Basel framework for controlling tail risk in trading books. J Int Money Finance 43, 107–130 (2014)CrossRef
Barucci, E., Milani, C.: Do European banks manipulate risk weights? Int Rev Financ Anal 59, 47–57 (2018)CrossRef
Beltratti, A., Stultz, R.M.: The credit crisis around the globe: why did some banks perform better? J Financ Econ 105(1), 1–17 (2012)CrossRef
Bevilacqua, M., Cannata, F., Cardarelli, S., Cristiano, R.A., Gallina, S., Petronzi, M.: The evolution of the Pillar 2 framework for banks: some thoughts after the financial crisis, Banca d’Italia, QEF n. 494 (2019)
Black, F., Scholes, M.: The pricing of options and corporate liabilities. J Polit Econ 81, 637–654 (1973)CrossRef
Brogi, M., Lagasio, V.: Sliced and diced: European banks’ business models and profitability. In: Bracchi, G., Filotto, U., Masciandaro, D. (eds.) The Italian banks: Which will be the New Normal Industrial, Institutional and Behavioural Economics, 2016 Report on the Italian Financial System, pp. 55–88. Milan: Fondazione Rosselli, Edibank (2016)
Chiaramonte, L., Casu, B.: Capital and liquidity ratios and financial distress. Evidence from the European banking industry. Br Account Rev 49, 138–161 (2017)CrossRef
Crosbie, P., Bohn J.: Modeling default risk. Working Paper KMV Corp. (2002)
Demirgüç-Kunt, A., Detragiache, E., Merrouche, O.: Bank capital: lessons from the financial crisis. J Money Credit Bank 45, 1147–1164 (2013)CrossRef
De Spiegeleer, J., Höcht, S., Marquet, I., Schoutens, W.: CoCo bonds and implied CET1 volatility. Quant Finance 17(6), 813–824 (2016)CrossRef
Dermine, J.: Bank regulations after the global financial crisis: good intentions and unintended evil. Eur Financ Manag 19(4), 658–674 (2013)CrossRef
Hong, H., Huang, J.-Z., Wu, D.: The information content of Basel III liquidity risk measures. J Financ Stab 15, 91–111 (2014)CrossRef
Liberadzki, M., Liberadzki, K.: The Contingent convertibles pricing models: CoCos credit spread analysis. In: Liberadzki, M., Liberadzki, K. (eds.) Contingent Convertible Bonds, Corporate Hybrid Securities and Preferred Shares, pp. 123–148. Cham: Palgrave Macmillan (2019)CrossRef
Lindquist, K.G.: Banks’ buffer capital: how important is risk. J Int Money Finance 23, 493–513 (2004)CrossRef
Mayes, D.G., Stremmel, H.: The effectiveness of capital adequacy measures in predicting bank distress, Chapters in SUERF Studies, SUERF—The European Money and Finance Forum (2014)
Merton, R.C.: On the pricing of corporate debt: the risk structure of interest rates. J Finance 29, 449–470 (1974)
Morkoetter, S., Schaller, M., Westerfeld, S.: The liquidity dynamics of bank defaults. Eur Financ Manag 20, 291–320 (2014)CrossRef
Vallascas, F., Hagendorff, J.: The risk sensitivity of capital requirements: evidence from an international sample of large banks. Rev Finance 17, 1947–1988 (2013)CrossRef
Vazquez, F., Federico, P.: Bank funding structures and risk: evidence from the global financial crisis. J Bank Finance 61, 1–14 (2015)CrossRef
Metadata
Title
Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules
Authors
Vincenzo Russo
Valentina Lagasio
Marina Brogi
Frank J. Fabozzi
Publication date
16-01-2020
Publisher
Springer Berlin Heidelberg
Published in
Annals of Finance / Issue 1/2020
Print ISSN: 1614-2446
Electronic ISSN: 1614-2454
DOI
https://doi.org/10.1007/s10436-020-00358-0

Other articles of this Issue 1/2020

Annals of Finance 1/2020 Go to the issue

Research Article

Infinitesimal generators for two-dimensional Lévy process-driven hypothesis testing

Research Article

A new approach to the rational expectations equilibrium: existence, optimality and incentive compatibility

Research Article

Asian options pricing in Hawkes-type jump-diffusion models

Research Article

Maximizing expected exponential utility of consumption with a constraint on expected time in poverty