Model risk and capital reserves

F.L.J. Kerkhof, B. Melenberg, J.M. Schumacher

Research output: Contribution to journalArticleScientificpeer-review

40 Citations (Scopus)

Abstract

We propose a procedure to take model risk into account in the computation of capital reserves. This addresses the need to make the allocation of capital reserves to positions in given markets dependent on the extent to which reliable models are available. The proposed procedure can be used in combination with any of the standard risk measures, such as Value-at-Risk and expected shortfall. We assume that models are obtained by usual econometric methods, which allows us to distinguish between estimation risk and misspecification risk. We discuss an additional source of risk which we refer to as identification risk. By way of illustration, we carry out calculations for equity and FX data sets. In both markets, estimation risk and misspecification risk together explain about half of the multiplication factors employed by the Bank for International Settlements (BIS).
Original languageEnglish
Pages (from-to)267-279
JournalJournal of Banking and Finance
Volume34
Issue number1
Publication statusPublished - 2010

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    Kerkhof, F. L. J., Melenberg, B., & Schumacher, J. M. (2010). Model risk and capital reserves. Journal of Banking and Finance, 34(1), 267-279.