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Messages from the Academic Literature on Risk Measurement for the Trading Book

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Messages from the Academic Literature on Risk Measurement for the Trading Book Basel Committee on Banking Supervision Working Paper No. 19 Messages from the academic literature on risk measurement for the trading book 31 January 2011 The Working Papers of the Basel Committee on Banking Supervision contain analysis carried out by experts of the Basel Committee or its working groups. They may also reflect work carried out by one or more member institutions or by its Secretariat. The subjects of the Working Papers are of topical interest to supervisors and are technical in character. The views expressed in the Working Papers are those of their authors and do not represent the official views of the Basel Committee, its member institutions or the BIS. Copies of publications are available from: Bank for International Settlements Communications CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 © Bank for International Settlements 2011. All rights reserved. Limited extracts may be reproduced or translated provided the source is stated. ISSN: 1561-8854 Contents Executive summary ..................................................................................................................1 1. Selected lessons on VaR implementation..............................................................1 2. Incorporating liquidity .............................................................................................1 3. Risk measures .......................................................................................................2 4. Stress testing practices for market risk ..................................................................2 5. Unified versus compartmentalised risk measurement ...........................................3 6. Risk management and value-at-risk in a systemic context ....................................3 0. Introduction......................................................................................................................5 1. Selected lessons on VaR implementation.......................................................................5 1.1 Overview ................................................................................................................5 1.2 Time horizon for regulatory VaR ............................................................................6 1.3 Time-varying volatility in VaR.................................................................................8 1.4 Backtesting VaR models ......................................................................................10 1.5 Conclusions..........................................................................................................11 2. Incorporating liquidity ....................................................................................................12 2.1 Overview ..............................................................................................................12 2.2 Exogenous liquidity ..............................................................................................14 2.3 Endogenous liquidity: motivation..........................................................................14 2.4 Endogenous liquidity and market risk for trading portfolios..................................15 2.5 Adjusting the VaR time horizon to account for liquidity risk .................................16 2.6 Conclusions..........................................................................................................17 3. Risk measures...............................................................................................................17 3.1 Overview ..............................................................................................................17 3.2 VaR ......................................................................................................................17 3.3 Expected shortfall.................................................................................................20 3.4 Spectral risk measures.........................................................................................23 3.5 Other risk measures.............................................................................................24 3.6 Conclusions..........................................................................................................25 4. Stress testing practices for market risk .........................................................................26 4.1 Overview ..............................................................................................................26 4.2 Incorporating stress testing into market-risk modelling ........................................26 4.3 Stressed VaR .......................................................................................................27 4.4 Conclusions..........................................................................................................28 5. Unified versus compartmentalised risk measurement .................................................. 29 5.1 Overview ............................................................................................................. 29 5.2 Aggregation of risk: diversification versus compounding effects......................... 30 5.3 Papers using the “bottom-up” approach.............................................................. 31 5.4 Papers using the “top-down” approach ............................................................... 35 5.5 Conclusions......................................................................................................... 37 6. Risk management and value-at-risk in a systemic context........................................... 38 6.1 Overview ............................................................................................................. 38 6.2 Intermediation, leverage and value-at-risk: empirical evidence........................... 39 6.3 What has all this to do with VaR-based regulation?............................................ 40 6.4 Conclusions......................................................................................................... 41 References............................................................................................................................. 43 Annex..................................................................................................................................... 50 Messages from the academic literature on risk measurement for the trading book Joint Working Group of the Research Task Force and the Trading Book Group of the Basel Committee on Banking Supervision Chair: Mr Klaus Duellmann, Deutsche Bundesbank, Frankfurt Mr Sirio Aramonte Board of Governors of the Federal Reserve System, Washington, DC Mr Philippe Durand Banque de France, Paris Mr Shun Kobayashi Bank of Japan, Tokyo Mr Myron Kwast Federal Deposit Insurance Corporation, Washington, DC Mr Jose A. Lopez Federal Reserve Bank of San Francisco Mr Giancarlo Mazzoni Bank of Italy, Rome Mr Peter Raupach Deutsche Bundesbank, Frankfurt Mr Martin Summer Austrian National Bank, Vienna Mr Jason Wu Board of Governors of the Federal Reserve System, Washington, DC Messages from the academic literature on risk measurement for the trading book Executive summary This report summarises the findings of an ad hoc working group that reviewed the academic literature relevant to the regulatory framework for the trading book. This project was carried out in the first half of 2010 acting upon a request from the Trading Book Group to the Research Task Force of the Basel Committee on Banking Supervision. This report reflects the views of the individual contributing authors and should not be construed as representing specific recommendations or guidance by the Basel Committee for national supervisors or financial institutions. The report builds on and extends previous work by the Research Task Force on the interaction of market and credit risk (see Basel Committee on Banking Supervision (2009a)). The literature review was complemented by feedback from academic experts at a workshop hosted by the Deutsche Bundesbank in April 2010, and reflects the state of the literature at this point in time. Please note that the term “value-at-risk” (VaR) should be interpreted henceforth in a broad sense as encompassing other common risk metrics, with the exception of Section 3 in which risk metrics are compared directly. The main findings of the group are summarised below in the order of the Sections of the report. 1. Selected lessons on VaR implementation There is no unique solution to the problem of the appropriate time horizon for risk measurement. The horizon depends on characteristics of the asset portfolio (such as, market liquidity) and the economic purpose of measuring its risk; for example, setting capital or setting loss limits for individual trading desks. Scaling of short-horizon VaR to a longer time horizon with the commonly used square-root- of-time scaling rule has been found to be an inaccurate approximation in many studies. This rule ignores future changes in portfolio composition. At present, there is no widely accepted approach for aggregating VaR measures based on different horizons. Time-varying volatility is a feature of many financial time series and can have important ramifications for VaR measurement. Time-varying volatility can give rise to issues regarding the potential pro-cyclical effects of VaR-based capital measures. The effects of time-varying volatility on the accuracy of simple VaR measures diminish
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