An analysis of VaR-based capital requirements |
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Institution: | 1. Federal Agency for Financial Market Stabilisation, Germany;2. Department of Econometrics and OR, Tilburg University, Netherlands;1. Fox School of Business, Temple University, Philadelphia, PA, United States;2. Department of Economics Marco Biagi, University of Modena and Reggio Emilia, Italy;3. CEFIN, University of Modena and Reggio Emilia, Italy |
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Abstract: | We study the behavior of a financial institution subject to capital requirements based on self-reported VaR measures, as in the Basel Committee's Internal Models Approach. We view these capital requirements and the associated backtesting procedure as a mechanism designed to induce financial institutions to reveal the risk of their investments and to support this risk with adequate levels of capital. Accordingly, we consider the simultaneous choice of an optimal dynamic reporting and investment strategy. Overall, we find that VaR-based capital requirements can be very effective not only in curbing portfolio risk but also in inducing revelation of this risk. |
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