A capital adequacy buffer model

We develop a new capital adequacy buffer model (CABM) that is sensitive to dynamic economic circumstances. The model, which measures additional bank capital required to compensate for fluctuating credit risk, is a novel combination of the Merton structural model, which measures distance to default and the timeless capital asset pricing model (CAPM), which measures additional returns to compensate for additional share price risk. We apply the model to a portfolio of mid-cap loan assets over a 10-year period that includes pre-GFC (global financial crisis), GFC and post-GFC. An analysis of actual defaults over this period shows the model to be far more accurate in determining the capital adequacy levels needed to counter credit risk than an unresponsive ratings model such as the Basel standardized approach.

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