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When more is less: Using multiple constraints to reduce tail risk

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  • Alexander, Gordon J.
  • Baptista, Alexandre M.
  • Yan, Shu

Abstract

Financial institutions suffered large trading losses during the 2007–2009 global financial crisis. These losses cast doubt on the effectiveness of regulations and risk management systems based on a single Value-at-Risk (VaR) constraint. While some researchers have recommended using Conditional Value-at-Risk (CVaR) to control tail risk, VaR remains popular among practitioners and regulators. Accordingly, our paper examines the effectiveness of multiple VaR constraints in controlling CVaR. Under certain conditions, we theoretically show that they are more effective than a single VaR constraint. Furthermore, we numerically find that the maximum CVaR permitted by the constraints is notably smaller than with a single constraint. These results suggest that regulations and risk management systems based on multiple VaR constraints are more effective in reducing tail risk than those based on a single VaR constraint.

Suggested Citation

  • Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2012. "When more is less: Using multiple constraints to reduce tail risk," Journal of Banking & Finance, Elsevier, vol. 36(10), pages 2693-2716.
  • Handle: RePEc:eee:jbfina:v:36:y:2012:i:10:p:2693-2716
    DOI: 10.1016/j.jbankfin.2011.08.002
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    References listed on IDEAS

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    Cited by:

    1. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2013. "A comparison of the original and revised Basel market risk frameworks for regulating bank capital," Journal of Economic Behavior & Organization, Elsevier, vol. 85(C), pages 249-268.
    2. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2014. "Bank regulation and international financial stability: A case against the 2006 Basel framework for controlling tail risk in trading books," Journal of International Money and Finance, Elsevier, vol. 43(C), pages 107-130.
    3. repec:spr:jknowl:v:8:y:2017:i:2:d:10.1007_s13132-016-0434-0 is not listed on IDEAS
    4. Righi, Marcelo Brutti & Ceretta, Paulo Sergio, 2013. "Risk prediction management and weak form market efficiency in Eurozone financial crisis," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 384-393.

    More about this item

    Keywords

    G11; G21; G28; Financial crisis; Financial institutions; Tail risk; Regulation; Risk management;

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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