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In some cases, setting capital equal to unexpected credit loss is encouraged by supervisors. For example, the U.S. Comptroller of the Currency’s Handbook for Large Bank Supervision (1995) states that, “capital is required as a cushion for a bank’s overall risk of unexpected loss.”
This study makes no claim that this objective function formally defines a firm’s optimal capital structure—indeed it almost certainly does not. It is, however, the objective function that is consistent with VaR-based capital allocation schemes and an approach commonly taken by banks according to the Basel Committee on Banking Supervision’s, (1999) survey results.
That is, it assumed that the term structure is flat, asset volatility is constant, the underlying asset pays no dividend or convenience yield, and all debt securities are pure discount issues.