Financial institutions in crisis: Modeling the endogeneity between credit risk and capital requirements∗

between credit risk and capital requirements This manuscript presents a credit-risk-based model for measuring and man-aging the default risk in financial institutions. The structural model determines the minimum level of equity required to yield a maximum acceptable cumula-tive probability of default given a bank’s existing liability structure. Our model is based on a modified version of the Geske (1977) structural compound option model. The model uses market information and integrates market discipline into managing default risk and estimating bank capital requirements. The model overcomes one of the major pitfalls of current risk-based capital require-ments: the lack of inclusion of the firm’s liability structure. The Geske model is particularly appealing for estimating default risk in financial institutions that have complex liability structures, as it builds in de-leveraging and endogenous default, thereby yielding more accurate estimates of default probability. The manuscript examines Lehman Brothers in the midst of the 2008 Financial Cri