Benchmarking of Market Risk Models For Determining Own Funds Requirements

Federico Cabañas and Lars Overby

As discussed in the previous chapter, during – and especially after – the global financial crisis, there has been widespread concern about the robustness of banks’ internal model estimates. In particular, significant differences were observed in the denominator of the capital ratios (ie, the capital requirements) produced by banks applying internal models to determine their risk-weighted assets (RWAs). Such concerns have only been reinforced by some institutions publicly announcing optimisation programmes aimed at reducing institutions’ RWAs by optimising the model outputs from the internal model.

The divergence in RWA calculations has traditionally been attributed to differences in the institutions’ portfolios and underlying risks; however, it has become clear that material differences also stem from an uneven implementation of the internal models. In particular, differences in both regulatory set parameters and modelling methodologies applied by institutions appear to explain a non-negligible share of the variation observed across banks. Furthermore, it should also not be excluded that some element of regulatory arbitrage, at least for some banks, has played a role during the