Private Equity and Regulatory Capital

Abstract

Regulatory Capital requirements for European banks have been put forward in the Basel II Capital Framework and subsequently in the Capital Requirements Directive (CRD) of the EU. We provide a detailed discussion of the capital requirements for private equity investments under the simple risk weight approach, the PD/LGD approach and the internal model approach. For the latter we present a structural model for which we calibrate the parameters from a proprietary dataset. We modify the standard Merton structural model to make it applicable in practice and to capture stylized facts of these investments. We also show how to implement the early default features of our model in a simulation algorithm with very low computational costs. Our results support capital requirements lower than in Basel II, but not as low as in CRD. A sensitivity analysis shows that this finding is robust to parameter uncertainty and stress scenarios. This is likely to give adverse incentives to banks for using advanced risk models.