Extending Basel Regulatory Capital Requirement under Economic Downturns

This paper studies credit risk management in banking industry and proposes a generic model for corporate loan portfolio loss distribution in economic downturns. Basel assumes a one-factor Gaussian copula for default correlations and introduces the regulatory capital on the ground of Vasicek process that works acceptably well in normal economic situations but not in recessions. In this paper, one-factor t-student copula is used for dependence structure of probability of Defaults (PDs), and Basel has been extended by introducing correlated PDs and Recovery Rates (RRs) through Clayton copula and the required economic capital is calculated accordingly. Finally, our findings suggest that Expected Shortfall (ES) safeguards banks against losses beyond the VaR level and it is a better risk metric in economic downturns comparing to VaR.