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Excerpt: I study capital adequacy rules based on Value-at-Risk (VaR), leverage ratios, and stress testing. VaR is the basis of Basel II, and all three approaches are proposed in Basel III.
Due to the 2007 credit crisis, the need for increased regulatory capital has been addressed by newly enacted legislation in the Dodd Frank Wall Street Reform and Consumer Protection Act, and the Basel III capital proposals. The existing and proposed capital adequacy rules are based on three methodologies: Value- at-Risk (VaR), maximum leverage ratios, and stress testing. The purpose of this paper is to analyze the impact of these three rules on the likelihood of financial institution catastrophic failure, and systemic risk in the economy