Back Testing Value-at-Risk

Back Testing Value-at-Risk



What is Basel II Back Testing Value-at-Risk?

The Basel II Capital Accord is a set of recommendations on banking law and regulation that applies to all banks. The objective is to stimulate the improvement of risk management which can be described under the “three pillars”:

  • Pillar 1 – Minimal regulatory capital requirements.

  • Pillar 2 – Supervisory review of capital adequacy.

  • Pillar 3 – Market discipline and disclosure.

Clients’ commitment to Basel II compliance can be demonstrated to regulators through evidence of systematic VaR Back Testing. VaR is the preferred measure of market risk as specified by the Basel II Accord.

Value-at-Risk (VaR) is a risk model which predicts the loss that an investment portfolio may experience over a period of time.

Back Testing is a technique used to compare the predicted losses from VaR with the actual losses realised at the end of the period of time.  This identifies instances where VaR has been underestimated, meaning a portfolio has experienced a loss greater or than the original VaR estimate. The results of the Back Testing can be used to refine the models used for the VaR predictions, making them more accurate and reducing the risk of unexpected losses.

Who will this affect?

The recommendations of the Basel II Accord extend to all banks, although compliance varies across jurisdiction as each central bank determines the method of implementation and associated requirements.

Key Points of Back Testing Value-at-Risk

The following minimum standards apply to calculating capital charge within a model measuring market risk;

  1. Data sets should be updated at least once every 3 months
  2. VaR must be calculated on a daily basis
  3. 99th percentile, one-tailed confidence interval is to be used
  4. A 10 day movement in prices should be used as the instant price shock
  5. 1 year is classified as a minimum period for “historical” observations

Related regulations

If you are affected by this regulation then you may also be affected by these:

How can UnaVista help with Back Testing Value-at-Risk?

UnaVista can assist you with a number of regulations, so that you don’t have to build separate solutions for each problem, future regulations can then be catered for through the platform when required. The specific way UnaVista can help you with Back Testing Value-at-Risk include:

  • Advanced understanding of discrepancies; automatically reconciles VaR estimates against actual and hypothetical losses in accordance with predefined analysis horizons.

  • Improve efficiency; supports a hierarchical approach to Back-Testing enabling reconciliation across multiple trading entities (aggregate, desk and book).

  • Manage exceptions better; supports exception handling workflow to facilitate investigation of VaR breaks with full auditing of the process.

  • Improve Basel II compliance; provides both daily and monthly reconciliation reports that can be used to demonstrate systematic Back Testing of VaR to financial regulators (contributing to Basel II Accord compliance).

  • Increase relevance of reports; facilitates concurrent user-driven analysis of Back Testing reports based on bespoke parameters and metrics.

  • Optimise the Back Testing process;evaluates the operational efficiency of the Back Testing process through a combination of KPI metrics and exception emails to:

  • Identify data discrepancies (e.g. missing data, data validation errors, late file submissions

  • Identify VaR breaks that have yet to be investigated

  • Escalate outstanding operational issues to management