Capital regulation and bank insolvency risk

Abstract

In this paper we propose risk measure of banks in two aspects using Heston model. We calculate the default probability under stochastic volatility structure and propose insolvency risk measure probability of default by adopting capital adequacy requirement. While the asset return is normal distribution in Merton's framework, the power law distribution is captured in Heston's model. Moreover, Merton's default probability only accounts for the debt paying ability of banks, our model risk measure aims to provide more conservative estimation of risk from bank regulation. We estimate all parameters and latent variables with the Bayesian inference, and obtain empirical results for two banks. We also propose the measure, the effect of capital buffer, which capture well the bankruptcy. This measure detected Lehman brokers' bankruptcy and proved Bank of America's stability.