Skewness of Returns, Capital Adequacy, and Mortgage Lending

We calibrate a simulation model of credit value-at-risk for mortgage lending to UK experience. Simulations to capture the skewness of returns that might arise in the context of a financial crisis suggest that the IRB calculations of the new Basel Accord can substantially understate prudential capital adequacy. The same model shows that raising capital requirements has only a small impact on bank funding costs. We conclude that Pillar 2 supervisory review should increase capital requirements above IRB levels for secured bank assets - those whose returns can potentially fall furthest, relative to other, normally "riskier" assets, in extreme outcomes.

DIMOU Paraskevi;  LAWRENCE Colin;  MILNE Alistair; 

2006-03-09

Springer Science + Business Media B.V.

JRC32215