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Financial Institutions In Crisis: Modeling The Endogeneity Between Credit Risk And Capital Requirements

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Executive Summary

This manuscript presents a credit-risk-based model for the establishment of minimum bank capital requirements. The structural model determines the minimum level of equity required to yield a maximum acceptable cumulative probability of default given a bank's existing liability structure. It is based on a modified version of the Geske (1977) structural model which assumes that new equity is issued to pay down maturing debt; this is particularly appropriate for financial institutions in times of distress. The model is traditionally used to accurately measure the term structure of a firm's default risk, given its existing capital structure and its associated market value of equity.

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