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Risk measurement feeds directly into the cost of balance sheet, making any change to calculation inputs part of a result that leads to winners and losers. In January 2016, the Basel Committee on Banking Supervision delivered a final rule on changing part of a bank’s market risk model calculations from Value-at-Risk (VaR) to the Expected Shortfall Method. This was a long-expected decision but not a perfect one; the methodologies for both VaR and Expected Shortfall have their supporters and detractors.
In this Finadium research report, we evaluate VaR and Expected Shortfall for business users who need to understand the basis for Fundamental Review of the Trading Book rules that will impact their activities. This is a business report, not a mathematical analysis: we define the terms, look at the pros and cons of the models, and compare the well understood VaR tail risk analysis methodologies to the relatively newer Expected Shortfall Method.
Regardless of which model readers consider “better,” the reality is that with this latest ruling, the Basel Committee has set in motion a chain of events that will redefine risk in explicit and implicit ways. As banks adjust their models, they will look closely at the inputs of the Expected Shortfall Method to measure their risks accordingly. Market practitioners should be aware of what these changes mean in practice.
This report has been written for any non-quant market practitioner who reads risk reports, works with quantitative analysts or must explain risk reports to executives, regulators or clients. Regulators and service providers not focused exclusively on quantitative risk analysis methodologies may also find this report useful in interpreting the Basel Committee’s new final rules.
This report is 30 pages with 6 exhibits.
TABLE OF CONTENTS
■ Executive Summary
■ The Change in Measuring Market Risk to Expected Shortfall
– Key Terms in the Expected Shortfall Conversation
■ The Basel Committee on Measuring Market Risk in the FRTB
■ The Pros and Cons of VaR
– What Went Wrong With VaR
■ Interest in the Expected Shortfall Method
– The Manipulation Argument
– Can Expected Shortfall be Backtested?
■ Implementing Expected Shortfall
■ What Expected Shortfall Means for Market Participants
■ About the Author
■ About Finadium