Quantifying market risk with Value-at-Risk or Expected Shortfall? – Consequences for capital requirements and model risk

Submitted on 7th September 2017

The Basel Committee on Banking Supervision recently proposed fundamental changes in the regulatory treatment of financial institutions׳ trading book positions. Among others, a replacement of Value-at-Risk (α=0.99α=0.99) by Expected Shortfall (α=0.975α=0.975) for the quantification of market risk is recommended. While this increases capital requirements for heavy tailed risks, its consequences for model risk related to the estimation process have not been explored. Hence, the aim of this paper is to analyse how both risk measures react to different sources of model risk in order to better understand the impact of the intended change in risk measures. Our results show that the Expected Shortfall (α=0.975α=0.975) is more sensitive towards regulatory arbitrage and parameter misspecification. We find that this is based on a trade-off between a model׳s ability to better capture the heavy tailed behaviour of risks and a higher vulnerability to model risk. These new aspects should be taken into account in the regulatory decision for Expected Shortfall (α=0.975α=0.975).

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Source
Journal of Economic Dynamics and Control
Length of Resource
19 pages
Author
Ralf Kellner, Daniel Rösch
Date Published
Publication Type
paper
Resource Type
academic