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Model risk and capital reserves

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Author Info

  • Kerkhof, Jeroen
  • Melenberg, Bertrand
  • Schumacher, Hans

Abstract

We propose a procedure to take model risk into account in the computation of capital reserves. This addresses the need to make the allocation of capital reserves to positions in given markets dependent on the extent to which reliable models are available. The proposed procedure can be used in combination with any of the standard risk measures, such as Value-at-Risk and expected shortfall. We assume that models are obtained by usual econometric methods, which allows us to distinguish between estimation risk and misspecification risk. We discuss an additional source of risk which we refer to as identification risk. By way of illustration, we carry out calculations for equity and FX data sets. In both markets, estimation risk and misspecification risk together explain about half of the multiplication factors employed by the Bank for International Settlements (BIS).

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 34 (2010)
Issue (Month): 1 (January)
Pages: 267-279

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Handle: RePEc:eee:jbfina:v:34:y:2010:i:1:p:267-279

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Web page: http://www.elsevier.com/locate/jbf

Related research

Keywords: Capital requirements Model risk Risk measures Estimation risk Misspecification risk Identification risk;

References

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  1. Frittelli, Marco & Rosazza Gianin, Emanuela, 2002. "Putting order in risk measures," Journal of Banking & Finance, Elsevier, vol. 26(7), pages 1473-1486, July.
  2. Kenneth D. West, 1994. "Asymptotic Inference About Predictive Ability," Macroeconomics 9410002, EconWPA.
  3. Kerkhof, F.L.J. & Melenberg, B., 2002. "Backtesting for Risk-Based Regulatory Capital," Discussion Paper 2002-110, Tilburg University, Center for Economic Research.
  4. Kaplanski, Guy & Levy, Haim, 2007. "Basel's value-at-risk capital requirement regulation: An efficiency analysis," Journal of Banking & Finance, Elsevier, vol. 31(6), pages 1887-1906, June.
  5. Acerbi, Carlo & Tasche, Dirk, 2002. "On the coherence of expected shortfall," Journal of Banking & Finance, Elsevier, vol. 26(7), pages 1487-1503, July.
  6. Denis Talay & Ziyu Zheng, 2002. "Worst case model risk management," Finance and Stochastics, Springer, vol. 6(4), pages 517-537.
  7. William A. Brock & Steven N. Durlauf & Kenneth D. West, 2004. "Model Uncertainty and Policy Evaluation: Some Theory and Empirics," NBER Working Papers 10916, National Bureau of Economic Research, Inc.
  8. Bongaerts, Dion & Charlier, Erwin, 2009. "Private equity and regulatory capital," Journal of Banking & Finance, Elsevier, vol. 33(7), pages 1211-1220, July.
  9. Heid, Frank, 2007. "The cyclical effects of the Basel II capital requirements," Journal of Banking & Finance, Elsevier, vol. 31(12), pages 3885-3900, December.
  10. Hull, John & Suo, Wulin, 2002. "A Methodology for Assessing Model Risk and its Application to the Implied Volatility Function Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(02), pages 297-318, June.
  11. Grané, A. & Veiga, H., 2008. "Accurate minimum capital risk requirements: A comparison of several approaches," Journal of Banking & Finance, Elsevier, vol. 32(11), pages 2482-2492, November.
  12. Philippe Artzner & Freddy Delbaen & Jean-Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228.
  13. Rama Cont, 2006. "Model uncertainty and its impact on the pricing of derivative instruments," Post-Print halshs-00002695, HAL.
  14. Christoffersen, Peter F, 1998. "Evaluating Interval Forecasts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 841-62, November.
  15. James L. Heckman, 1999. "Causal Parameters and Policy Analysis in Economcs: A Twentieth Century Retrospective," NBER Working Papers 7333, National Bureau of Economic Research, Inc.
  16. M.J.B. Hall, 1996. "The amendment to the capital accord to incorporate market risk," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 49(197), pages 271-277.
  17. Lars Peter Hansen & Thomas J. Sargent, 2007. "Introduction to Robustness," Introductory Chapters, Princeton University Press.
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  19. M.J.B. Hall, 1996. "The amendment to the capital accord to incorporate market risk," BNL Quarterly Review, Banca Nazionale del Lavoro, vol. 49(197), pages 271-277.
  20. Hans Föllmer & Alexander Schied, 2002. "Convex measures of risk and trading constraints," Finance and Stochastics, Springer, vol. 6(4), pages 429-447.
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Citations

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Cited by:
  1. Pflug, Georg Ch. & Pichler, Alois & Wozabal, David, 2012. "The 1/N investment strategy is optimal under high model ambiguity," Journal of Banking & Finance, Elsevier, vol. 36(2), pages 410-417.
  2. Thomas Breuer & Imre Csiszar, 2013. "Measuring Model Risk," Papers 1301.4832, arXiv.org.
  3. repec:hal:journl:halshs-00587779 is not listed on IDEAS
  4. Aussenegg, Wolfgang & Resch, Florian & Winkler, Gerhard, 2011. "Pitfalls and remedies in testing the calibration quality of rating systems," Journal of Banking & Finance, Elsevier, vol. 35(3), pages 698-708, March.
  5. Christophe Boucher & Gregory Jannin & Bertrand Maillet & Patrick Kouontchou, 2013. "An Economic Evaluation of Model Risk in Long-term Asset Allocations," Working Papers halshs-00825303, HAL.
  6. Christophe Boucher & Benjamin Hamidi & Patrick Kouontchou & Bertrand Maillet, 2012. "Une évaluation économique du risque de modèle pour les investisseurs de long terme," Revue économique, Presses de Sciences-Po, vol. 63(3), pages 591-600.
  7. Bertram, Philip & Sibbertsen, Philipp & Stahl, Gerhard, 2011. "About the Impact of Model Risk on Capital Reserves: A Quantitative Analysis," Diskussionspapiere der Wirtschaftswissenschaftlichen Fakultät der Leibniz Universität Hannover dp-469, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
  8. Thomas Breuer & Martin Summer, 2013. "Stress Test Robustness: Recent Advances and Open Problems," Financial Stability Report, Oesterreichische Nationalbank (Austrian Central Bank), issue 25.
  9. Nikola Tarashev, 2009. "Measuring portfolio credit risk correctly: why parameter uncertainty matters," BIS Working Papers 280, Bank for International Settlements.
  10. Christophe Boucher & Benjamin Hamidi & Patrick Kouontchou & Bertrand Maillet, 2012. "Une Evaluation Economique du risque de modèle pour les investisseurs de long-terme," Working Papers halshs-00825337, HAL.

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