Application of the Merton model to estimate the probability of breaching the capital requirements under Basel III rules

  • Vincenzo Russo
  • Valentina Lagasio
  • Marina BrogiEmail author
  • Frank J. Fabozzi
Research Article


In this paper, we estimate the probability of a financial institution breaching the Common Equity Tier 1 capital under Basel III rules. We do so by applying the Merton model, where balance sheet data and market data are used to match the probability of default implied by the model with the probability of default implied by market quotations for credit default swaps. We provide an empirical analysis for several banks classified by the Financial Stability Board and the Basel Committee on Banking Supervision as Global Systemically Important Financial Institutions, evaluating how the probability of breaching the Common Equity Tier 1 Capital evolved from 2005 to 2015. We find that higher Common Equity Tier 1 Capital ratios do not necessarily imply lower probabilities of breaching capital requirements and vice versa. We also focus on the asset volatility calibrated according to our model and we find that it appears to be a good proxy for the risk-weighted asset density.


Probability of breaching Basel III rules Merton model Credit default swap Global Systemically Important Financial Institutions 

JEL Classification

G21 G28 



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Copyright information

© Springer-Verlag GmbH Germany, part of Springer Nature 2020

Authors and Affiliations

  1. 1.Group Risk ManagementAssicurazioni Generali S.p.A.MilanItaly
  2. 2.Department of ManagementUniversity of Rome “La Sapienza”RomeItaly
  3. 3.EDHEC Business SchoolNiceFrance

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