An economic approach to market risk

Abstract

Value at Risk models are often employed for the purpose of evaluating market risk as a basis for determining capital requirements of financial intermediaries. We argue that this type of model delivers highly pro-cyclical results. As a result, capital requirements are rather low at the peak of an asset price bubble, right before the losses occur. In addition, the pro-cyclicality of regulation provides an incentive for banks to buy assets when prices go up and to sell them when prices go down, thereby amplifying price fluctuations. Against this background this paper delivers two important contributions. First, we evaluate minimum standards for Value at Risk that should help to reduce its weaknesses. Second, we develop a capital add-on for market risk that is, in contrast to Value at Risk, linked to economic fundamentals.