VAR and Stress Tests : The Impact of Fat-Tail Risk and Systemic Risk on Commercial Banks in Hong Kong and China

This study shows that the statistical property of the commercial banks' rate of returns can be used to explain the resistance to using Value-at-risk (VaR) and stress tests to determine banks' capital adequacy. We showed that “fat-tail” risk requires more capital than the “normal tail” risk estimated by VaR, which assumes normal distribution. The puzzle that most banks in Europe and Asia maintained higher capital levels than required by regulators before the 2008 financial crisis can be reinterpreted as rational action to protect financial companies against abnormal fat-tail risk, which may reflect inside information, such as off-balance sheet activities, rather than regulations. Micro- and macro-prudential policies are needed not only to discourage fat-tail risk seeking, but also to cover the higher social costs caused by higher systemic risk and bank diversification, which are affected by the heaviness of the tail and limited liability of bank charter