Managing Market Risk in Europe: The Performance of Value-at-Risk Models in Different Economic Conditions and the Impact of Basel II.5 on Financial Stability

Abstract: Major regulatory standards, like the Basel II.5 accord, refer to a bank's internal Value-at-Risk model for determining its respective amount of market risk and for imposing adequate capital charges on the bank. This demonstrates the importance of a high quality of disclosed VaR figures - not only during non-crisis periods, but also especially during crisis periods when market risk increases. The purpose of this paper is to empirically test the disclosed VaR figures of a sample of six large European banks between 2004/2005-2013 by analyzing the VaR performance over the whole sample period, comparing the performance during non-crisis and crisis periods, and testing for a possible improvement effect after the crisis. We furthermore analyze the impact of the Basel II.5 standards of 2011 on required market risk charges and test for systemic risk in Europe as a possible obstacle to financial stability. The necessary daily P&L and VaR data for our analysis is obtained from graphs published in the banks' annual reports by applying a Matlab-based data extraction approach. Even though we find a non-uniform VaR performance over the whole sample period and in the non-crisis period, there exists a strong evidence of VaR understatement during the financial crisis in our sample and no significant performance improvement of the disclosed VaR figures in the aftermath of the crisis, compared to the pre-crisis period. Furthermore, despite the fact that the Basel II.5 accord increases the imposed market risk charges by a factor of two to three, we find a significant existence of systemic risk in the sample of the six European banks.