Macro Model-Based Stress Testing of Basel II Capital Requirements

Esa Jokivuolle, Kimmo Virolainen and Oskari Vähämaa

The new international framework for banks’ capital regulation, known as Basel II, poses a challenge to both banks and their supervisors. The new rules on capital adequacy are meant to better align banks’ capital requirements with their true risks. This wellmotivated aim may have some side effects, which will require careful monitoring and scrutiny. In particular, capital requirements that are tied to banks’ actively measured risks will be more volatile than the previous constant capital requirements. They may also reinforce the business cycle because banks’ asset risks, such as credit risks measured with internal credit ratings, tend to move in accordance with the business cycle. Such procyclicality may arise if banks are forced to cut back their lending as a result of deteriorating ratings and thus increasing minimum capital requirements in downturns.

The Basel II framework addresses these concerns by stating that banks are expected to hold capital in excess of the minimum requirement. Capital buffers can partly absorb unexpected increases in future minimum capital requirements in a downturn and hence may attenuate the procyclical effect.²²For example, Heid (2007) and Repullo and