![Risk.net](https://www.risk.net/sites/default/files/styles/print_logo/public/2018-09/print-logo.png?itok=1TpHrpuP)
Last orders at the VAR
Inaccurate risk-of-loss estimates threaten to load extra capital charges on US dealers
If a hangover is punishment for a night of heavy drinking, higher capital charges are banks’ penance for running greater risks in their trading portfolios.
The wild market swings of end-2018 hit dealers’ market risk models like shots of tequila to the stomach. Yet the latest quarterly market risk disclosures suggest the hangover was relatively mild.
The eight US global systemically important banks (G-Sibs) saw their value-at-risk-based capital charges surge 23% compared with the quarter before.
This component of the market risk capital requirement tracks each bank’s average daily projected maximum risk of loss, estimated using VAR models. As such, it reflects banks’ own guesses of the amount of capital needed to absorb trading losses.
But much like the optimistic imbiber underestimating their alcohol tolerance, banks’ VAR models can underestimate their maximum daily risk of loss. When actual losses exceed modelled estimates, a VAR breach is the result. These are red flags to regulators. Frequent breaches imply a bank’s VAR model is not fit for purpose. The VAR-based capital charge is calculated by multiplying a bank’s projected average daily loss estimate by three. But if a bank sees more than four VAR breaches over a rolling 250-day period, the multiplier climbs in increments to a maximum of four with every additional breach.
Much like the optimistic imbiber underestimating their alcohol tolerance, banks’ VAR models can underestimate their maximum daily risk of loss. When actual losses exceed modelled estimates, a VAR breach is the result
After a rocky fourth quarter, some banks are facing the prospect of multiplier increases. State Street has seen four VAR breaches over the past 250 trading days. The US unit of Credit Suisse is in the same position. Bank of America has three breaches. BNP Paribas is already over the limit with eight, and is subject to a 3.75 multiplier. That should dissuade these banks from lowballing their loss estimates in the months ahead.
Still, the consequences of frequent VAR breaches should not be overstated. The US market risk requirements include five other components, which act as an extra layer of protection. The stressed VAR charge, for example, forces dealers to hold enough capital to cover expected maximum losses in a period of severe market tumult. The specific risk add-on and de minimis positions add-on capture risks that may not be fully covered in a bank’s VAR model.
The VAR-based capital charge accounts for less than 10% of US G-Sibs market risk capital charges. So, models and standardised formulas used to capture other aspects of market risk are of much greater importance. But the threat of multiplier increases may prompt banks to be more conservative with their VAR estimates in future.
Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.
To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe
You are currently unable to print this content. Please contact info@risk.net to find out more.
You are currently unable to copy this content. Please contact info@risk.net to find out more.
Copyright Infopro Digital Limited. All rights reserved.
As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (point 2.4), printing is limited to a single copy.
If you would like to purchase additional rights please email info@risk.net
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. As outlined in our terms and conditions, https://www.infopro-digital.com/terms-and-conditions/subscriptions/ (clause 2.4), an Authorised User may only make one copy of the materials for their own personal use. You must also comply with the restrictions in clause 2.5.
If you would like to purchase additional rights please email info@risk.net
More on Our take
Podcast: Lorenzo Ravagli on why the skew is for the many
JP Morgan quant proposes a unified framework for trading the volatility skew premium
Quants see promise in DeBerta’s untangled reading
Improved language models are able to grasp context better
Counterparty risk model links defaults to portfolio values
Fed’s Michael Pykhtin proposes using copula models to capture effects of margin calls on default risk
Does Basel’s internal loss multiplier add up?
As US agencies mull capital reforms, one regulator questions past losses as an indicator of future op risk
Is JSCC-CFTC stalemate about to be broken?
Japan CCP gains allies in battle to clear yen swaps for US clients, but CFTC shakeup could dash hopes
What T+1 risk? Dealers shake off FX concerns
Predictions of increased settlement risk and later-in-the-day trading have yet to materialise
Go your own way: departures pose new challenges for CFTC
Loss of Democratic majority would impede chairman’s ambitions for regulatory agenda
Altice’s dropdown is a warning for European creditors
Carve-out used to shield assets from lenders may occur in a fifth of European deals