Basel's Value-at-Risk Capital Requirement Regulation: An Efficiency Analysis

39 Pages Posted: 20 Sep 2004 Last revised: 29 Sep 2013

Guy Kaplanski

Bar-Ilan University - Graduate School of Business Administration

Haim Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration; Fordham University

Abstract

We analyze the optimal portfolio policies of expected utility maximizing agents under VaR Capital Requirement (VaR-CR) regulation in comparison to the optimal policy under exogenously-imposed VaR Limit (VaR-L) and Limited-Expected-Loss (LEL) regulations. With VaR-CR regulation the agent strategy consists of simultaneous decisions on both the portfolio VaR and on the implied amount of required eligible capital. As a result, the performance of VaR-CR regulation depends on its design (the parameter n) and the agent preferences. We show that an optimal VaR-CR regulation allows the regulator on the one hand, to completely eliminate the exposure to the largest losses, which may jeopardize the existence of the institution, and on the other hand, to restrain the portfolio exposure to all other losses. These results rationalize the current Basel regulations. However, the analysis shows also that there is an optimal level of required eligible capital from the regulator standpoint. Counter-intuitively, any requirement above this optimal level is inefficient as it leads to a smaller amount of actually maintained eligible capital and thereby to a larger exposure to the most adverse states of the word. Unfortunately, the current Basel's range of required levels (n = 3 -4) is within this inefficient range. Moreover, with an inefficient regulation the agent might employ an inefficient reporting and disclosure procedure.

Keywords: Value-at-Risk, VaR, Basel, regulations, Capital Requirement regulations

JEL Classification: G11, G18, G28, E58

Suggested Citation

Kaplanski, Guy and Levy, Haim, Basel's Value-at-Risk Capital Requirement Regulation: An Efficiency Analysis. Journal of Banking & Finance, Vol. 31, No. 6, pp. 1887-1906, June 2007. Available at SSRN: https://ssrn.com/abstract=593003 or http://dx.doi.org/10.2139/ssrn.593003

Guy Kaplanski (Contact Author)

Bar-Ilan University - Graduate School of Business Administration ( email )

Ramat Gan
Israel

Haim Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

HOME PAGE: http://pluto.huji.ac.il/~mshlevy/

Fordham University ( email )

140 West 62nd Street
New York, NY 10023
United States

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