#05-16
The Basel 2 Approach to Bank Operational Risk: Regulation on the Wrong Track
Richard J. Herring
Abstract: Over the past fifteen years, leading banks around the world have adopted a new paradigm for financial risk management focused on the concept of economic capital. “Economic capital” is the amount of capital a bank requires to achieve a given level of protection against default for its creditors. Operationally, the question is usually posed as “How much capital should the bank have to achieve a target rating for its long-term debt?” This is a straightforward inference from Merton’s model of the pricing of risky corporate debt: given the institution’s net asset value and the target probability of default, economic capital is the amount needed to achieve the target probability of default.1 Applications of this approach include Risk Adjusted Return of Capital (RAROC) or Value at Risk (VaR).
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