Improving the Measurement of Capital Adequacy

The future of economic capital and stress testing.

Over the better part of the last 20 years, banks have been developing credit risk economic capital tools to help measure and manage the risk and risk-adjusted returns of credit portfolios. But the recent financial crisis raised some significant questions about the effectiveness of the specific economic capital tools that many institutions used.

In 2008 and 2009, the Federal Reserve, ignoring banks’ often poorly performing economic capital models, turned to a universal “stress test” to judge whether banks were adequately capitalized to survive losses in two scenarios: a continued economic downturn and one that significantly worsened. Banks’ economic capital models could not answer this question. They could show what a future distribution of losses might look like, but not what losses might be in a specific economic scenario.

Stress testing has now become the primary lens through which banks and regulators assess capital adequacy. Banks have developed a new suite of stress testing models that link credit risk outcomes to macroeconomic variables. At the same time, banks have had to maintain and enhance existing economic capital models both for regulatory reasons and to support internal pricing and performance measurement tools.

This article examines the implicit choices that banks made in the initial development of credit risk economic capital models and why a different approach was needed for stress testing. We conclude by asking whether a more dramatic rethink of banks’ modeling infrastructure is required to continue to enhance and evolve risk management capabilities.

Improving the Measurement of Capital Adequacy