TY - JOUR
T1 - Basel's value-at-risk capital requirement regulation
T2 - An efficiency analysis
AU - Kaplanski, Guy
AU - Levy, Haim
PY - 2007/6
Y1 - 2007/6
N2 - 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 world. 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.
AB - 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 world. 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.
KW - Basel's regulations
KW - Capital requirement regulations
KW - Value-at-risk
UR - http://www.scopus.com/inward/record.url?scp=34248137969&partnerID=8YFLogxK
U2 - 10.1016/j.jbankfin.2007.02.007
DO - 10.1016/j.jbankfin.2007.02.007
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AN - SCOPUS:34248137969
SN - 0378-4266
VL - 31
SP - 1887
EP - 1906
JO - Journal of Banking and Finance
JF - Journal of Banking and Finance
IS - 6
ER -