Unexpected Shortfalls of Expected Shortfall: Extreme Default Profiles and Regulatory Arbitrage
23 Pages Posted: 11 Dec 2014 Last revised: 17 Sep 2015
Date Written: September 16, 2015
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: Suggested Citation