Journal of Risk Model Validation

The utility of Basel III rules on excessive violations of internal risk models

Wayne Tarrant

  • Basel III allows firms to use proprietary internal risk models until a certain level of failure.
  • Violations of the historical empirical distributions have far fewer violations.
  • Using a combination of different risk measures, levels, and durations gives better quantification of risk.

The Basel III international regulatory framework for banks calls for the adoption of historical empirical distributions should a bank’s internal models fail in a significant way. If the historical distribution is the fallback to an internal model, it is important to know if the empirical distribution gives a better view of future reality. In this paper, we look at the efficacy of risk measures on energy markets and across several different stock market indexes. We calculate both the value-at-risk (VaR) and the expected shortfall (ES) on each of these data sets as well as on selected portfolios of these assets. We consider several different durations and levels for the historical risk measures, looking at the number of violations that Basel III measures for its requirements. We also calculate different error measurements for the VaR and ES. Using our results, we make some recommendations concerning the Basel III framework. The computations here strongly indicate that the Bank for International Settlements should adopt harsher guidelines than are presently in place. Further, we would offer firms the option of using internal models and reporting multiple risk measures or using historical empirical measures and only reporting a single measure.

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