Unexpected Shortfalls of Expected Shortfall: Extreme Default Profiles and Regulatory Arbitrage

23 Pages Posted: 11 Dec 2014 Last revised: 17 Sep 2015

See all articles by Pablo Koch-Medina

Pablo Koch-Medina

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Cosimo Munari

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Date Written: September 16, 2015

Abstract

The purpose of this paper is to dispel some common misunderstandings about capital adequacy rules based on Expected Shortfall. We establish that, from a theoretical perspective, Expected Shortfall based regulation can provide a misleading assessment of tail behaviour, does not necessarily protect liability holders' interests much better than Value-at-Risk based regulation, and may also allow for regulatory arbitrage when used as a global solvency measure. We also show that, for a value-maximizing financial institution, the benefits derived from protecting its franchise may not be sufficient to disincentivize excessive risk taking. We further interpret our results in the context of portfolio risk measurement. Our results do not invalidate the possible merits of Expected Shortfall as a risk measure but instead highlight the need for its cautious use in the context of capital adequacy regimes and of portfolio risk control.

Keywords: expected shortfall, value-at-risk, financial regulation, tail behaviour, default behaviour

JEL Classification: C60, G18, G28

Suggested Citation

Koch-Medina, Pablo and Munari, Cosimo, Unexpected Shortfalls of Expected Shortfall: Extreme Default Profiles and Regulatory Arbitrage (September 16, 2015). Available at SSRN: https://ssrn.com/abstract=2536549 or http://dx.doi.org/10.2139/ssrn.2536549

Pablo Koch-Medina (Contact Author)

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Cosimo Munari

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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