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Value-at-Risk (VaR) models often are used to estimate the equity investment that is required to limit the default rate on funding debt. Typical VaR "buffer stock" capital calculations produce biased estimates. To ensure accuracy, VaR must be modified by: (1) measuring loss relative to initial market value; and (2) augmenting VaR to account for the interest income required by investors. While this issue has been identified in the market risk setting, it has yet to be recognized in the credit risk literature. Credit VaR techniques, as typically described, are not an appropriate basis for setting equity capital allocations.
Advocates for internal model-based capital regulation argue that this approach will reduce costs and remove distortions that are created by rules-based capital regulations. These claims are examined using a Merton-style model of deposit insurance. Analysis shows that internal model-based capital estimates are biased by safety-net-generated funding subsidies that convey to bank shareholders when market and credit risk regulatory capital requirements are set using bank internal model estimates. These subsidies are not uniform across the risk spectrum, and, as a consequence, internal model regulatory capital requirements will cause distortions in bank lending behavior.