A new report from Finadium evaluates the Expected Shortfall Method, a risk management methodology supported by the Basel Committee alongside VaR for the Fundamental Review of the Trading Book. 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. This report is written for non-quants who read risk reports, work with quantitative analysts, or explain risk reports to executives, regulators or clients.
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.
As a general idea, Expected Shortfall is meant to capture more information about tail risk than VaR. At a 99% confidence internal, VaR was supposed to provide information about possible losses that would occur in almost every statistical case; it so happened that the events of 2008 were outside of the 99% confidence interval at major banks. Expected Shortfall on the other hand looks at the probability of losses and focuses more than VaR on the tail risk exposure. The idea is to focus on the most unlikely loss outcomes instead of the most likely profitable outcomes.
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.
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