The senior management and board of directors of a financial institution have an important role, which is to ensure that capitalization is sufficient to cover the risks that are being taken. Their duty is to the shareholders and, in banking, also to the regulators. Thus, a major task facing the risk manager in a bank or financial firm is to assess the level of risk relative to the capitalization, at various activity levels and within each line of business. Also, the value of the firm is reflected by its credit rating, which is linked to the probability of default over a long time horizon. Thus, good risk management should encompass a rigorous stress testing programme that is designed to increase the probability that the firm remains solvent over this time horizon.
The solvency of banks is particularly important for the stability of the financial system. Governments, central banks and the Basel Committee have a strong interest in systemic risk, where insolvency in one sector of an economy can lead to a national – if not global – economic crisis. Thus the global recession following the stock market crash of 1987 prompted a revision of banking regulations and, in the mid 1990s, new minimum requirements for the regulatory risk capital owned by banks were imposed on all banks in the G10 countries, and these were later adopted by most of the developed countries in the world.
The computation of regulatory capital for various activities in each ...