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A word of caution on calculating market -based minimum capital risk requirements

A word of caution on calculating market -based minimum capital risk requirements
A word of caution on calculating market -based minimum capital risk requirements
This paper demonstrates that the use of GARCH-type models for the calculation of minimum capital risk requirements (MCRRs) may lead to the production of inaccurate and therefore inefficient capital requirements. We show that this inaccuracy stems from the fact that GARCH models typically overstate the degree of persistence in return volatility. A simple modification to the model is found to improve the accuracy of MCRR estimates in both back- and out-of-sample tests. Given that internal risk management models are currently in widespread usage in some parts of the world (most notably the USA), and will soon be permitted for EC banks and investment firms, we believe that our paper should serve as a valuable caution to risk management practitioners who are using, or intend to use this popular class of models.
minimum capital risk requirements, internal risk management models, volatility persistence
0378-4266
1557-1574
Brooks, C.
91d99e42-37f5-4b2b-87a2-c3df0c926b5f
Clare, A.D.
e9a9923a-dee5-4521-a5e1-d404befa7069
Persand, G.
c1b50342-bfb4-4a40-9f03-b352ba2076f2
Brooks, C.
91d99e42-37f5-4b2b-87a2-c3df0c926b5f
Clare, A.D.
e9a9923a-dee5-4521-a5e1-d404befa7069
Persand, G.
c1b50342-bfb4-4a40-9f03-b352ba2076f2

Brooks, C., Clare, A.D. and Persand, G. (2000) A word of caution on calculating market -based minimum capital risk requirements. Journal of Banking and Finance, 24 (10), 1557-1574. (doi:10.1016/S0378-4266(99)00092-8).

Record type: Article

Abstract

This paper demonstrates that the use of GARCH-type models for the calculation of minimum capital risk requirements (MCRRs) may lead to the production of inaccurate and therefore inefficient capital requirements. We show that this inaccuracy stems from the fact that GARCH models typically overstate the degree of persistence in return volatility. A simple modification to the model is found to improve the accuracy of MCRR estimates in both back- and out-of-sample tests. Given that internal risk management models are currently in widespread usage in some parts of the world (most notably the USA), and will soon be permitted for EC banks and investment firms, we believe that our paper should serve as a valuable caution to risk management practitioners who are using, or intend to use this popular class of models.

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More information

Published date: 2000
Keywords: minimum capital risk requirements, internal risk management models, volatility persistence
Organisations: Management

Identifiers

Local EPrints ID: 35884
URI: http://eprints.soton.ac.uk/id/eprint/35884
ISSN: 0378-4266
PURE UUID: d942da7e-021f-4ca0-a7c0-db8e19f344ec

Catalogue record

Date deposited: 23 May 2006
Last modified: 15 Mar 2024 07:54

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Contributors

Author: C. Brooks
Author: A.D. Clare
Author: G. Persand

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