Working Paper: CEPR ID: DP10889
Authors: Dennis Bams; Magdalena Pisa; Christian Wolff
Abstract: This paper addresses issues related to industry heterogeneity, default clustering and parameter uncertainty of capital requirements in US retail loan portfolios. Using a multi-factor model of credit risk, we show that the Basel II capital requirements overstate the riskiness of small businesses. Retail exposures are a much safer investment than the regulator would suggest. We find that sensitivity to the common risk factors is low and that small business risk is predominantly a reflection of idiosyncratic risk. Our results show that only 0.00-3.39% of the asset variability is explained by economy-wide risk factors. The remaining 96.61%-100.00% of small business risk is due to changes in the firm-specific characteristics. Moreover, both expected and unexpected losses are time dependent. Their shifts over the course of financial crisis cause uncertainty in the provisions level and capital requirements. Importantly, our estimates of asset correlations are significantly lower than any available estimates for corporate firms. Our results are based on a new, representative dataset of US retail businesses from 2005 to 2011 and give fundamental insights into the US economy.
Keywords: capital requirements
JEL Codes: G17; L14; L25
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Basel II capital requirements (G28) | overstate the riskiness of small business retail exposures (G21) |
| asset variability explained by economy-wide risk factors (G31) | small business risk is predominantly idiosyncratic (L26) |
| firm-specific characteristics (G32) | small business risk is predominantly idiosyncratic (L26) |
| time-dependent expected and unexpected losses (C41) | impact provisions and capital requirements (G28) |
| regulatory framework (G38) | distort capital allocation for small businesses (H32) |
| distortion in capital allocation (D61) | disadvantage more creditworthy firms (G32) |