The impact of the market risk of capital regulations on bank activities
Banking has a unique role in the well-being of an economy. This role makes banksone of the most heavily regulated and supervised industries. In order to strengthenthe soundness and stability of banking systems, regulators require banks to holdadequate capital. While credit risk was the only risk that was covered by the originalBasle Accord, with the 1996 amendment, banks have also been required to assigncapital for their market risk starting from 1998.In this research, the impact of the market risk capital regulations on bank capitallevels and derivative activities is investigated. In addition, this study also evaluatesthe impact of using different approaches that are allowed to be used while calculatingthe required market risk capital, as well as the accuracy of VaR models.The implementation of the market risk capital regulations can influence banks eitherby increasing their capital or by decreasing their trading activities and in particulartrading derivative activities. The literature review concerning capital regulationsillustrates that in particular the impact of these regulations on bank capital levels andderivative activities is an issue that has not yet been explored. In order to fill this gap,the changes in capital and derivatives usage ratios are modelled by using a partialadjustment framework. The main results of this analysis suggest that theimplementation of the market risk capital regulations has a significant and positiveimpact on the risk-based capital ratios of BHCs. However, the results do not indicateany impact of these regulations on derivative activities. The empirical findings also demonstrate that there is no significant relationship between capital and derivatives. The market risk capital regulations allow the use of either a standardised approach or the VaR methodologies to determine the required capital amounts to cover marketrisk. In order to evaluate these approaches, firstly differences on bank VaR practicesare investigated by employing a documentary analysis. The documentary analysis isconducted to demonstrate the differences in bank VaR practices by comparing theVaR models of 25 international banks. The survey results demonstrate that there, isno industry consensus on the methodology for calculating VaR. This analysis alsoindicates that the assumptions in estimating VaR models vary considerably amongfinancial institutions. Therefore, it is very difficult for financial market participants tomake comparisons across institutions by considering single VaR values.Secondly, the required capital amounts are calculated for two hypothetical foreignexchange portfolios by using both the standardised and three different VaRmethodologies, and then these capital amounts are compared. These simulations areconducted to understand to what extent the market risk capital regulationsapproaches produce different outcomes on the capital levels. The results indicate thatthe VaR estimates are dependent upon the VaR methodology.Thirdly, three backtesting methodologies are applied to the VaR models. The resultsindicate that a VaR model that provides accurate estimates for a specific portfoliocould fail when the portfolio composition changes.The results of the simulations indicate that the market risk capital regulations do notprovide a `level playing field' for banks that are subject to these regulations. Inaddition, giving an option to banks to determine the VaR methodology could create amoral hazard problem as banks may choose an inaccurate model that provides lessrequired capital amounts.
Year of publication: |
2006
|
---|---|
Authors: | Eksi, Emrah |
Publisher: |
Emrah Eksi |
Subject: | Banking | Capital | Risk-Based Capital Regulations | Derivatives | Market risk | Value at risk | Backtesting |
Saved in:
freely available
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