Abstract: Important shortcomings limit the appeal of the direct use of bank internal models to set regulatory capital requirements for bank credit risks. Common approaches for calculating credit value for risk-based capital requirements produce biased estimates that do not control bank funding cost subsidies and the moral hazard externalities that mandate the need for bank capital regulation. If, alternatively, banks were required to issue subordinated debt that has both a minimum market value and maximum acceptable probability of default at issuance, banks would, thereby, be implicitly required to set their equity capital in a manner that limits both the probability of bank default and the expected loss on insured deposits. This mandatory subordinated debt issuance policy alone can control the externalities created by a government safety net without the need for a formal regulatory capital requirement for bank credit risk. This chapter demonstrates that the proposed subordinated debt requirement implicitly imposes a credit risk capital requirement that can be estimated using bank internal models. As such, the proposed subordinated debt policy can be viewed is an indirect way of imposing internal model based regulatory capital requirements for bank credit risks.

Keywords: capital regulation, bank regulation, internal model, safety net,