Market Risk Regulatory Evolution – A shift from VaR?

VaR (Value at Risk) has been synonymous with market risk measurement for decades. This is specifically true for the banking industry since most banks use VaR to measure and manage their market risk. VaR is widely studied and modeled, easily quantifies the level of risk (think back-testing) and is well understood. However, in the regulatory evolution that followed the Global Financial Crisis, several of its shortcomings were highlighted.

VaR models - which did well during normal conditions – failed in some ways in the extreme conditions experienced during 2008 the crisis. VaR is a pro-cyclical approach which is based on a single potential loss threshold, and it was concluded that a better through-the-cycle approach was needed which would also show meaningful insights during stress periods. This pushed regulators to endorse incremental measures like Stressed Var in Basel 2.5 and more recently alternative measures like Expected Shortfall (ES) as seen with FRTB.

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