A Limit-Risk Capital Adequacy Rule: An Alternative Approach to Capital Adequacy Regulation for Banks with an Empirical Application to Switzerland

The paper presents an alternative to the capital adequacy requirements proposed by the Basle Committee on Banking Supervision. Akin to the value-at-risk method, the alternative approach envisages national supervisory authorities setting a maximum risk of insolvency that no bank would be allowed to exceed, and each bank complying by holding a capital-to-asset ratio commensurate with its overhead costs and with the expected value and volatility of its rate of return. The alternative approach offers a number of advantages, including a framework for assessing the costs and benefits that increasing capital standards entails. The paper discusses problems of implementation and applies the approach to data taken from the great majority of banks that operated in Switzerland in the period 1987-93. The results suggest, among other things, that current capital requirements in Switzerland tend to overcharge low-risk banks and to undercharge high-risk ones.