VaR Models and the new capital requirement formula for trading portfolio: a Brazilian market analysis

Abstract

Taking into account the new capital requirement formula for banks’ trading portfolio, which has arisen in the set of regulatory rules changes driven by the subprime crisis and the recent permission for Brazilian banks to use internal models in computing capital requirements, we created a theoretical portfolio, com¬posed by government bonds, stocks and currencies, based on Brazilian banks’ profile of trading portfolio in order to assess two closely related issues: (i) the accuracy of Value at Risk (VaR) models used by banks to compute market risk and (ii) the adequacy of the new rule to bear real and hypothetical portfolio losses. We found that despite VaR models, in general, underestimate market risk, the capital charge generated by these models, when the new capital requirement formula is used, has shown to be overly conservative in all performed tests. Additionally, we propose two modifications to the capital requirement formula which makes it less punitive and still reliable.