Regulatory Capital Management under Basel II

Under the Basel II international capital framework, 1 banks must maintain a minimum level of capital against the risks taken to ensure capital adequacy. Besides the economic risk transferred by hedging loans or bonds with CDSs, a key and sometimes primary motivation for banks to engage in such risk mitigation is the resulting capital relief, since the Basel capital framework explicitly recognizes credit risk mitigation (CRM) techniques as an effective risk-management tools which can significantly reduce credit risk. 2 Basel II revised the approach to credit risk mitigation, allowing a wider range of credit risk mitigants that achieve regulatory capital relief compared to Basel I. The tight capital situation of banks has been a concern, particularly in the aftermath of the Lehman crisis, but it was also highlighted by the EBA stress tests, which were followed by requests that banks close the gap between their actual capital base and the requested threshold. According, capital management has become a high-priority exercise for most banks. Advanced financial institutions view capital management as a holistic, firm-wide function encouraging both regulatory and economic capital discipline and consistency as opposed to a post-business care, where costly and cumbersome capital optimization initiatives seek to restore the capital base. These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.