Academic journal article Federal Reserve Bank of New York Economic Policy Review

Value at Risk and Precommitment: Approaches to Market Risk Regulation

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Value at Risk and Precommitment: Approaches to Market Risk Regulation

Article excerpt

1. INTRODUCTION

Traditionally, regulation of banks has focused on the risk entailed in bank loans. Loans are typically nontraded assets. In recent years, another component of bank assets has become increasingly important: assets actively traded in the financial markets.(1) These assets form the "trading book" of a bank, in contrast to the "banking book," which includes the nontraded assets such as loans. Though for most large banks the trading book is still relatively small compared with the banking book, its rising importance makes the market risk of banks an important regulatory concern.

In January 1996, the European Union (EU) adopted rules to regulate the market risk exposure of banks, setting risk-based capital requirements for the trading books of banks and securities houses. At this point, one must ask what the purpose of such regulatory capital is. We proceed under the hypothesis that the purpose of regulatory capital is to provide a buffer for contingencies involving large losses, in order to protect both depositors and the system as a whole by reducing the likelihood that the system will fail. In this paper, we look at two different ways of calculating bank capital for market risk exposures and compare their performance in delivering an adequate cover for large losses.

The approach taken by the EU is to use a "hardlink" regime that sets a relation between exposure and capital requirement exogenously. The adopted requirements, known as the standardised approach, laid down rules for calculating the capital requirement for each separate risk category (that is, U.K. equities, U.S. equities, U.K. interest rate risk, and so on). These are added together to give the overall requirement. A weakness of this method is that it does not take into account the diversification benefits of holding different risks in the same portfolio, and thus yields an excessive capital requirement for a large diversified player. One way to correct for this problem is to use the value-at-risk (VAR) models that some banks have developed to measure overall portfolio risk. The Basle Supervisors' Committee has now agreed to offer an alternative regime, with capital requirements based on such internal VaR models, and the EU is considering whether to follow suit.

While the measure of risk exposure employed by the two regimes is different, in both approaches the regulator lays down the parameters for the calculation of the capital requirement for a given exposure. Thus, both regimes embody a hard link.

Under VaR, the capital requirement for a particular portfolio is calculated using the internal risk management models of the banks.(2) For any portfolio, the aim is to estimate a level of potential loss over a particular time period that would only be exceeded with a given probability. Both the probability and the period are laid down by the regulator. Basle has set these at 1 percent and ten days, respectively. The capital requirement is based on this potential loss.(3)

But using VaR comes at a price. The regulator must try to ensure that the internal model used to calculate risk is accurate. Otherwise, banks might misrepresent their risk exposure. However, back-testing to check the accuracy of an internal VaR model is difficult in the sense that a large number of observations are needed before an accurate judgment can be made about the model.(4) This motivated economists Kupiec and O'Brien (1997) of the Federal Reserve Board to put forward a new "precommitment" approach (PCA) that proposes the use of a "soft link." Such a link is not externally imposed, but arises endogenously. In the case of the proposed precommitment approach, the link between exposures held and the capital backing them is induced by the threat of penalties whenever trading losses exceed a level prespecified by the bank (known as the precommitment capital).

Specifically, under PCA, banks are asked to choose a level of capital to back their trading books for a given period of time (for example, one quarter). …

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