When Enough is Not Enough: Structural Credit Risk Based Estimation of Bank Capital

Abstract

This paper proposes the use of a structural credit risk model to analyze the economic capital of banks. The particular model used in this paper is unique in that it has both endogenous default and a more robust depiction of the liability structure. As a result, it represents a reasonable model for identifying distress in the fi nancial sector. The model yields several useful metrics for evaluating the solvency and economic capital of financial institutions. Contrary to static measures of capital adequacy such as a fixed percentage of assets, which do not capture the true condition of a financial institution, the model is forward - looking in nature and can be used in a dynamic capacity to monitor and estimate the capital needs for banks. Empirical results show that, although the largest US Bank Holding Companies were well capitalized by regulatory standards, there was a dearth of economic capital as the Financial Crisis unfolded in 2008. The implication is that capital levels should be time-varying and conditional upon the health of the particular bank and the financial system as a whole.