Basel violations, volatility model variants and value at risk: Optimization of performance deviations in banks

Abstract

Basel penalties originate from VaR violations, based on the type of variance models and the estimation of VaR thresholds employed by the bank, which leads to excess regulatory capital charge held and can affect banks’ risk taking ability and thus its profitability. Different approaches are used to evaluate the performance of variance models and forecasts of the VaR thresholds i.e. hypothesis tests, back-testing procedures and Basel Accord regulatory calculations for penalty zones. A multi-criteria performance measure named as analytical hierarchy process has been introduced in this study. The approach helps in evaluating and selection of the optimal internal model based on performance evaluation techniques objectively which, in turn, may help in the selection of best volatility internal model for reduction in the VaR violations and thus leaving more capital in the hands of the banks for profitable ventures.