Bank Risk Management with Value-at-Risk and Stress Testing: An Alternative to Conditional Value-at-Risk?

Abstract

Recognizing the drawbacks of Value-at-Risk (VaR) as a measure of tail risk, researchers have advocated replacing it with Conditional Value-at-Risk (CVaR). However, the current popularity of VaR and Stress Testing (ST) among bank regulators raises the question of whether a risk management system based on both VaR and ST constraints is an effective alternative to a system based on CVaR. We find that when the VaR and ST bounds are appropriately chosen and short selling is disallowed, the constraints lead to the selection of portfolios with relatively small CVaRs. However, when short selling is allowed, the constraints may not lead to the selection of such portfolios. Since large banks often have short positions in their trading books, regulators should be aware that the joint use of VaR and ST is unreliable in controlling tail risk for such banks. Furthermore, noting the tremendous growth in bank trading activities, our results suggest that the current bank capital regulatory framework is of questionable effectiveness in promoting the soundness of banking systems.