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Using Expected Shortfall for Credit Risk Regulation

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  • Osmundsen, Kjartan Kloster

    (UiS)

Abstract

The Basel Committee’s minimum capital requirement function for banks’ credit risk is based on value at risk. This paper performs a statistical and economic analysis of the consequences of instead basing it on expected shortfall, a switch that has already been set in motion for market risk. The empirical analysis is carried out by means of both theoretical simulations and real data from a Norwegian savings bank group’s corporate portfolio. Expected shortfall has some well known conceptual advantages compared to value at risk, primarily a better ability to capture tail risk. It is also sub-additive in gen- eral, thus always reflecting the positive effect of diversification. These two aspects are examined in detail, in addition to comparing parameter sensitivity, estimation stabil- ity and backtesting methods for the two risk measures. All comparisons are conducted within the Basel Committee’s minimum capital requirement framework. The findings support a switch from value at risk to expected shortfall for credit risk modelling.

Suggested Citation

  • Osmundsen, Kjartan Kloster, 2017. "Using Expected Shortfall for Credit Risk Regulation," UiS Working Papers in Economics and Finance 2017/4, University of Stavanger.
    • Handle: RePEc:hhs:stavef:2017_004
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    File URL: http://www1.uis.no/ansatt/odegaard/uis_wps_econ_fin/uis_wps_2017_04_osmundsen.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Expected shortfall; credit risk; bank regulation; Basel III; tail risk;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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