An Introduction to Value-At-Risk, Fourth Edition

Chapter 7

REGULATORY ISSUES AND STRESS-TESTING

We consider briefiy, and in overview manneronly, some relevant issues in bank regulatory capital. We then discuss the issue of stress-testing of value-at-risk (VaR) models.

CAPITAL ADEQUACY

The European Union (EU) Capital Adequacy Directive (CAD) has been in place since January 1996. It defines the capital requirement calculation that banks and securities houses must comply with based on the relocation of positions between the trading book and the non-trading, or banking, book.

Model compliance

As part of complying with CAD I, the Bank of England (BoE) has adopted a procedure it uses to recognise models and the capital requirements which will be generated from these models. Eligible models can cover:

• options risk and interest rate risk in derivatives in the trading book;
• foreign exchange (FX) risk in the banking and trading books.

There is a standard approach for banks without recognised models and a more complex approach for those with recognised models, which will normally result in a lower capital requirement for a given quantity of position risk.

Models eligible for recognition fall into two categories:

• pricing models (for complex swaps, vanilla and exotic options);
• risk aggregation models (those which summarise and facilitate management of risk).

The types of risk aggregation models which the BoE can recognise for CAD purposes ...