A Word of Caution on Calculating Market-Based Minimum Capital Risk Requirements

Posted: 4 Dec 2004

See all articles by Chris Brooks

Chris Brooks

University of Reading - ICMA Centre

Andrew Clare

City University London - Sir John Cass Business School

Gita Persand

University of Bristol - Department of Economics

Abstract

This paper demonstrates that the use of GARCH-type models for the calculation of minimum capital risk requirements (MCRRs) may lead to the production of inaccurate and therefore inefficient capital requirements. We show that this inaccuracy stems from the fact that GARCH models typically overstate the degree of persistence in return volatility. A simple modification to the model is found to improve the accuracy of MCRR estimates in both back- and out-of-sample tests. Given that internal risk management models are currently in widespread usage in some parts of the world (most notably the USA), and will soon be permitted for EC banks and investment firms, we believe that our paper should serve as a valuable caution to risk management practitioners who are using, or intend to use this popular class of models.

Keywords: Minimum capital risk requirements, internal risk management models, volatility persistence

JEL Classification: C14, C15, G13

Suggested Citation

Brooks, Chris and Clare, Andrew D. and Persand, Gita, A Word of Caution on Calculating Market-Based Minimum Capital Risk Requirements. Journal of Banking and Finance, Vol. 14, No. 10, pp. 1557-1574, 2000; Cass Business School Research Paper. Available at SSRN: https://ssrn.com/abstract=626699

Chris Brooks (Contact Author)

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 118 931 82 39 (Phone)
+44 118 931 47 41 (Fax)

Andrew D. Clare

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Gita Persand

University of Bristol - Department of Economics ( email )

8 Woodland Road
Bristol BS8 ITN
United Kingdom

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