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Evaluating the Basle Guidelines for Backtesting Banks' Internal Risk Management Models

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  • Lucas, Andre

Abstract

The 1996 Amendment to the Baste capital accord to incorporate market risks constitutes a breakthrough in the determination of capital requirements. Rather than dictating these requirements through a uniform supervisory approach, banks are allowed to use their own, internal models for computing the capital required. In order to mitigate moral hazard problems and stimulate banks to use adequate internal models, the models must be subjected to a backtesting procedure. If a model produces too many incorrect predictions, increased capital requirements result. This paper provides an evaluation of the current internal models approach in conjunction with the proposed backtesting procedure. In particular, using a stylized representation of the present supervisory framework, we investigate whether banks are provided with the right incentives to come up with the correct internal model. We find that under the current regulatory framework banks are prone to under-reporting their true market risk. A much stricter penalty scheme is required in order to align banks' incentives with those of the supervisor. We check the sensitivity of our results to changes in the length of the planning horizon, portfolio risk, time preferences, risk attitudes, and the distribution of financial returns.

Suggested Citation

  • Lucas, Andre, 2001. "Evaluating the Basle Guidelines for Backtesting Banks' Internal Risk Management Models," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 826-846, August.
  • Handle: RePEc:mcb:jmoncb:v:33:y:2001:i:3:p:826-46
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    Cited by:

    1. Alexander, Gordon J. & Baptista, Alexandre M. & Yan, Shu, 2012. "Bank regulation and stability: An examination of the Basel market risk framework," Discussion Papers 09/2012, Deutsche Bundesbank.
    2. 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.
    3. Gyöngyi Bugár & Anita Ratting, 2016. "Revision of the quantification of market risk in the Basel III regulatory framework," Financial and Economic Review, Magyar Nemzeti Bank (Central Bank of Hungary), vol. 15(1), pages 33-50.
    4. 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.
    5. Pérignon, Christophe & Deng, Zi Yin & Wang, Zhi Jun, 2008. "Do banks overstate their Value-at-Risk?," Journal of Banking & Finance, Elsevier, vol. 32(5), pages 783-794, May.
    6. Ralf Sabiwalsky, 2012. "Does Basel II Pillar 3 Risk Exposure Data help to Identify Risky Banks?," SFB 649 Discussion Papers SFB649DP2012-008, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
    7. 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.
    8. Bernardo da Veiga & Felix Chan & Michael McAleer, 2009. "It Pays to Violate: How Effective are the Basel Accord Penalties?," CIRJE F-Series CIRJE-F-683, CIRJE, Faculty of Economics, University of Tokyo.

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