Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Basel is fighting the last war and that rather badly

The Basel Committee has put out a set of proposals for revising
the Basel II capital requirements.

One of the things that Basel is now correcting is a discrepancy
between the risk level of 99% that was laid down during the market
risk amendment of 1996 to Basel I and the level of 99.9% that was laid
down in Basel II in 2004 for the banking book. The proposed Guidelines for computing
capital for incremental risk in the trading book
require risk in
the trading book to be measured at the 99.9% level and at a one year
horizon. The Committee admits that:

Owing to the high confidence standard and long capital horizon of
the IRC, robust direct validation of the IRC model through standard
backtesting methods at the 99.9%/one-year soundness standard will not
be possible. Accordingly, validation of an IRC model necessarily must
rely more heavily on indirect methods including but not limited to
stress tests, sensitivity analyses and scenario analyses, to assess
its qualitative and quantitative reasonableness, particularly with
regard to the model’s treatment of concentrations. Given the nature of
the IRC soundness standard such tests must not be limited to the range
of events experienced historically. The validation of an IRC model
represents an ongoing process in which supervisors and firms jointly
determine the exact set of validation procedures to be employed.

I think this is a futile attempt to preserve the 1990s era risk
management technology (value at risk, linear correlations and normal
distributions) embodied in Basel II. The only way to get to the 99.9%
level in any plausible way is to use fat tailed distributions (say
student with four degrees of freedom) explicitly and also to move to
non linear dependence models (copulas); when one is doing all this,
one might as well give up the theoretically discredited value at risk
measure and move to a “coherent risk measure” like
expected shortfall. Suggesting the use of stress tests as a way to
arrive at the 99.9% standard is akin to changing the subject when you
do not know what to say.

What I found even more troubling is the following statement in the
other consultation document “Revisions to the Basel II market
risk framework”

In addition, a bank must calculate a ‘stressed
value-at-risk’ based on the 10- day, 99th percentile, one-tailed
confidence interval value-at-risk measure of the current portfolio,
with value-at-risk model inputs calibrated to historical data from a
period of significant financial stress relevant to the firm’s
portfolio. For most portfolios, the Committee would consider a
12-month period relating to significant losses in 2007/08 to be a
period of such stress, although other relevant periods could be
considered by banks, subject to supervisory approval. This stressed
value-at-risk should be calculated at least weekly.

This document has been in the making for a longer period and
perhaps reflects the Committee’s thinking at an earlier point of
time – it still talks of 99% instead of 99.9%. That apart, what
puzzled me is the belief that 2007-08 represented the ultimate in terms
of financial stress. Since they say 2007/08 and not 2007/2008, it
clearly refers to the financial year 2007-08 and excludes the severe
stress in the second half of calendar year 2008.

More importantly, the idea that even calendar year 2008 is the
ultimate in stress is debatable. There have been no sovereign defaults
(ignoring Ecuador) while the big risk for 2009 and 2010 is certainly
the possible default of a G7 sovereign and the related possibility of
the break-up of the Eurozone. Risk managers who think that the worst is
over in the current crisis are not worth their salaries today. I am
shocked that the Basel Committee is encouraging this kind of shoddy
thinking.

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