Evaluation of the Basel VaR-based market risk charge and proposals for a needed adjustment

Abstract

This analysis shows that in high risk situations the Basel II guidelines fail in the attempt to cushion against large losses by higher capital requirements. One of the factors causing this problem is that the built-in positive incentive of the penalty factor resulting from the Basel backtesting is set too weak. Therefore, this paper proposes a new procedure for market risk regulation and it demonstrates how this works with real time series. A comparison study shows that contrary to the existing Basel regulation the proposition presented here has the intended quality as a built-in incentive for choosing a reliable forecasting model. By including the expected shortfall as a further measure of risk this paper's concept yields a steeper increase of the penalty factor and as a consequence a stronger effect of risk underestimation on the capital requirement. The recent proposal of the Basel Committee on Banking Supervision may have the same weakness as the Basel II regulation because it is constructed in an analogous manner.