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Using Expected Shortfall for Credit Risk Regulation

Kjartan Kloster Osmundsen
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Kjartan Kloster Osmundsen: UiS, Postal: University of Stavanger, NO-4036 Stavanger, Norway

No 2017/4, UiS Working Papers in Economics and Finance from University of Stavanger

Abstract: The Basel Committee’s minimum capital requirement function for banks’ credit risk is based on value at risk. This paper performs a statistical and economic analysis of the consequences of instead basing it on expected shortfall, a switch that has already been set in motion for market risk. The empirical analysis is carried out by means of both theoretical simulations and real data from a Norwegian savings bank group’s corporate portfolio. Expected shortfall has some well known conceptual advantages compared to value at risk, primarily a better ability to capture tail risk. It is also sub-additive in gen- eral, thus always reflecting the positive effect of diversification. These two aspects are examined in detail, in addition to comparing parameter sensitivity, estimation stabil- ity and backtesting methods for the two risk measures. All comparisons are conducted within the Basel Committee’s minimum capital requirement framework. The findings support a switch from value at risk to expected shortfall for credit risk modelling.

Keywords: Expected shortfall; credit risk; bank regulation; Basel III; tail risk (search for similar items in EconPapers)
JEL-codes: G10 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2017-03-30
New Economics Papers: this item is included in nep-rmg
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