Liquidity Risk, Credit Risk, Market Risk and Bank Capital

With a sample of twelve US bond indices spanning different maturities, credit ratings and industry sectors, we investigate the impact of new bank capital regulation for trading portfolios introduced by Basel III. Specifically, we estimate the new capital requirements for (a) liquidity risk and credit risk through the so called Incremental Risk Charge, and (b) the risk of extreme market movements, which we measure with stress tests based on the 2007-2009 financial crisis. We find that capital requirements should increase substantially more than suggested by extensive impact studies conducted by the regulators with the participation of a large sample of banks. We suggest that the lower impact on capital reported by the banks may be due to the assumed risk reduction stemming from their hedging strategies. However, their effectiveness in crisis scenarios remains an open question.