Risk Tolerance Concepts and Scenario Analysis of Bank Capital

Håkan Andersson and Andreas Lindell

To ensure a stable global financial system it is necessary that banks and other financial institutions hold substantial capital buffers to protect against large unexpected losses. When assessing the capital adequacy a number of concerns need to be addressed. The minimum capital requirement, as defined by regulatory bodies, should be met and additional buffers should be provided to cover for risks not adequately captured in the calculation of the minimum requirement. Moreover, the rating ambition of a bank is an important input together with strategic considerations and peer group analysis. Shareholders, investors and depositors need to be confident that a bank will not fall in distress whatever the future state of the economy. On the other hand shareholders have an interest in high return on equity, which would, ceteris paribus, require as low a capital level as possible. This mix of constraints makes the evaluation of the required capital level an inspiring business and a rewarding one if dealt with in a professional manner.

A bank’s result is affected by a large number of external factors, such as market variables, variables governing the behaviour of clients, etc. A statistical