Skewness of Returns, Capital Adequacy, and Mortgage Lending
- Resource Type
- Authors
- Alistair Milne; Paraskevi Dimou; Colin Lawrence
- Source
- Journal of Financial Services Research. 28:135-161
- Subject
- Economics and Econometrics
Capital adequacy ratio
Financial capital
Cost of capital
Accounting
Economic capital
Risk-weighted asset
Risk-adjusted return on capital
Capital requirement
Capital employed
Economics
Financial system
Finance
- Language
- ISSN
- 1573-0735
0920-8550
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.