A Model for Measuring Financial Risks

Abstract

According to the prescriptions of the Basle Committee on Banking Supervision, as from the end of 1997, or earlier if their supervisory authority so prescribes, banks will be required to measure and apply capital requirements in respect of their market risks in addition to their credit risks. The Basle Committee has proposed its own - simplified - method of calculation (the standardized approach), but has left banks free to use measurement systems they have developed internally (the models approach). In this paper, the regulatory conditions for the use of internal models, such as the specification of market risk factors, quantitative standards (including backtesting) and stress testing, are reviewed and a general continuous-time model put forward. This is used to determine the measures of volatility and turbulence that serve as the synthetic instruments for monitoring the riskiness of a portfolio. The significance of value-at-risk (Var) is then examined and an analytical approximation proposed. A discussion follows of the reasons (including the empirical evidence contrary to the assumption of normality) which led the Basle Committee to prescribe a multiplicative factor for Var in determining the capital requirement for market risks. The Var is then compared with the value of a put option guaranteeing a minimum level of shareholders' equity. This leads to a call for the present regulations to be developed in the direction of an integrated approach that will determine the value of a portfolio and its volatility as a function of the various financial and credit factors (and of the concentration of exposures towards given sectors/borrowers). The paper concludes with the presentation of some applications showing how the proposed approach can be implemented in practice.