Calculating Systemic Risk Capital Requirements: A Factor Model Approach

Abstract

Macro prudential regulation requires a rigorous process for calculating bank capital charges based on their systemic risk. Using data from the largest global financial institutions we document the existence of extreme event dependence between banks during the recent financial crisis. Subsequently, we extend existing approaches by proposing a model that employs a credit portfolio framework that accounts for such extreme event dependence, and we quantify the level of capital shortfall when this characteristic is ignored. Furthermore, regulatory and economic capital are aligned by introducing capital requirements through a mark to market valuation approach that more accurately accounts for the risk of credit downgrades.