Robust Capital Requirements with Model Risk

Pauline Barrieu and Claudia Ravanelli

Economic Notes, 2015, vol. 44, issue 1, 1-28

Abstract: type="main" xml:lang="en">

We study capital requirements when the bank's econometric model only approximately describes the dynamics of portfolio returns—which is virtually always the case in practice. We derive a simple formula for capital requirements based on a first-order Taylor expansion of the Value at Risk around a ‘model confidence’ parameter. This formula allows to reflect the bank's confidence in the econometric model into capital requirements in a theoretically consistent manner. Numerical and empirical applications show that our formula provides valuable information for quantifying capital requirements under model risk.

Date: 2015
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