A Stochastic Dominance Approach to the Basel III Dilemma: Expected Shortfall or VaR?

Chia-Lin Chang (), Juan Jimenez-Martin, Esfandiar Maasoumi, Michael McAleer and Teodosio Pérez-Amaral
Additional contact information
Teodosio Pérez-Amaral: Departamento de Fundamentos del Análisis Económico II (Economía Cuantitativa). Universidad Complutense de Madrid., https://www.ucm.es/fundamentos-analisis-economico2

No 2015-16, Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico

Abstract: The Basel Committee on Banking Supervision (BCBS) (2013) recently proposed shifting the quantitative risk metrics system from Value-at-Risk (VaR) to Expected Shortfall (ES). The BCBS (2013) noted that “a number of weaknesses have been identified with using VaR for determining regulatory capital requirements, including its inability to capture tail risk” (p. 3). For this reason, the Basel Committee is considering the use of ES, which is a coherent risk measure and has already become common in the insurance industry, though not yet in the banking industry. While ES is mathematically superior to VaR in that it does not show “tail risk” and is a coherent risk measure in being subadditive, its practical implementation and large calculation requirements may pose operational challenges to financial firms. Moreover, previous empirical findings based only on means and standard deviations suggested that VaR and ES were very similar in most practical cases, while ES could be less precise because of its larger variance. In this paper we find that ES is computationally feasible using personal computers and, contrary to previous research, it is shown that there is a stochastic difference between the 97.5% ES and 99% VaR. In the Gaussian case, they are similar but not equal, while in other cases they can differ substantially: in fat-tailed conditional distributions, on the one hand, 97.5%-ES would imply higher risk forecasts, while on the other, it provides a smaller down-side risk than using the 99%-VaR. It is found that the empirical results in the paper generally support the proposals of the Basel Committee.

Keywords: Stochastic dominance; Value-at-Risk; Expected Shortfall; Optimizing strategy; Basel III Accord. (search for similar items in EconPapers)
JEL-codes: C22 C53 G11 G17 G32 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2015-11
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cfn, nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://eprints.ucm.es/id/eprint/34141/1/1516.pdf (application/pdf)

Related works:
Working Paper: A Stochastic Dominance Approach to the Basel III Dilemma: Expected Shortfall or VaR? (2015)
Working Paper: A Stochastic Dominance Approach to the Basel III Dilemma: Expected Shortfall or VaR? (2015)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ucm:doicae:1516

Ordering information: This working paper can be ordered from
Facultad de Ciencias Económicas y Empresariales. Pabellón prefabricado, 1ª Planta, ala norte. Campus de Somosaguas, 28223 - POZUELO DE ALARCÓN (MADRID)
https://www.ucm.es/f ... -de-trabajo-del-icae

Access Statistics for this paper

More papers in Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico Contact information at EDIRC.
Bibliographic data for series maintained by Águeda González Abad ().