It Pays to Violate: How Effective are the Basel Accord Penalties?

Bernardo da Veiga, Felix Chan and Michael McAleer

No EI 2009-39, Econometric Institute Research Papers from Erasmus University Rotterdam, Erasmus School of Economics (ESE), Econometric Institute

Abstract: The internal models amendment to the Basel Accord allows banks to use internal models to forecast Value-at-Risk (VaR) thresholds, which are used to calculate the required capital that banks must hold in reserve as a protection against negative changes in the value of their trading portfolios. As capital reserves lead to an opportunity cost to banks, it is likely that banks could be tempted to use models that underpredict risk, and hence lead to low capital charges. In order to avoid this problem the Basel Accord introduced a backtesting procedure, whereby banks using models that led to excessive violations are penalised through higher capital charges. This paper investigates the performance of five popular volatility models that can be used to forecast VaR thresholds under a variety of distributional assumptions. The results suggest that, within the current constraints and the penalty structure of the Basel Accord, the lowest capital charges arise when using models that lead to excessive violations, thereby suggesting the current penalty structure is not severe enough to control risk management. In addition, this paper suggests an alternative penalty structure that is more effective at aligning the interests of banks and regulators.

Keywords: Basel accord penalties; GARCH; Value-at-Risk (VaR); forecasting; risk management; simulations; violations (search for similar items in EconPapers)
JEL-codes: C22 C53 G11 G17 G32 (search for similar items in EconPapers)
Date: 2009-11-24
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Working Paper: It Pays to Violate: How Effective are the Basel Accord Penalties? (2009)
Working Paper: It Pays to Violate: How Effective are the Basel Accord Penalties? (2009)
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