Downturn Credit Portfolio Risk, Regulatory Capital and Prudential Incentives*

Abstract

ABSTRACTThis paper analyzes the level and cyclicality of bank capital requirement in relation to (i) the model methodologies through‐the‐cycle and point‐in‐time, (ii) four distinct downturn loss rate given default concepts, and (iii) US corporate and mortgage loans. The major finding is that less accurate models may lead to a lower bank capital requirement for real estate loans. In other words, the current capital regulations may not support the development of credit portfolio risk measurement models as these would lead to higher capital requirements and hence lower lending volumes. The finding explains why risk measurement techniques in real estate lending may be less developed than in other credit risk instruments. In addition, various policy recommendations for prudential regulators are made.