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VaR and Liquidity Risk.Impact on Market Behaviour and Measurement Issues

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  • Luca Erzegovesi

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    (DISA, Faculty of Economics, Trento University)

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    Abstract

    Current trends in international banking supervision following the 1996 Amendment to the Basel Accord emphasise market risk control based upon internal Value-at-risk (VaR) models. This paper discusses the merits and drawbacks of VaR models in the light of their impact on market liquidity. After a preliminary review of basic concepts and measures regarding market risk, market friction and liquidity risk, the arguments supporting the internal models approach to supervision on market risk are discussed, in the light of the debate on the limitations and possible enhancements of VaR models. In particular, adverse systemic effects of widespread risk management practices are considered. Risk measurement models dealing with liquidity risk are then examined in detail, in order to verify their potential for application in the field. We conclude that VaR models are still far from effectively treating market and liquidity risk in their multi-faceted aspects. Regulatory guidelines are right in recognising the importance of internal risk control systems. Implementation of those guidelines might inadvertently encourage mechanic application of VaR models, with adverse systemic effects.

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    Bibliographic Info

    Paper provided by Department of Computer and Management Sciences, University of Trento, Italy in its series Alea Tech Reports with number 014.

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    Length: 44 pages
    Date of creation: Feb 2002
    Date of revision: 14 Jun 2008
    Handle: RePEc:trt:aleatr:014

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