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1 August 2013 CFA Institute Journal Review

Basel Committee’s Fundamental Review of the Trading Book: A Commentary (Digest Summary)

  1. Marc L. Ross, CFA

The Basel Committee on Banking Supervision has proposed a change in methodology to address deficiencies in the quantification of financial risk. But the authors suggest that using accounting rather than financial modeling to gauge and administer financial institutions’ capital adequacy is a better approach.

What’s Inside?

In 2009, the Basel Committee on Banking Supervision initiated a review of the market risk framework and trading book. The committee concluded that value at risk (VaR) falls short in the proper quantification of risk and suggested that the expected shortfall methodology would better address extreme events. The authors’ view is that the Basel Committee should base capital adequacy review on accounting rather than risk models.

How Is This Research Useful to Practitioners?

Risk models often suffer from misinterpretation and flawed application. In particular, VaR came up short during the recent financial crisis. Its shortcomings lay in its failure to project a worst-case loss. Rather, the model would attempt to predict that a loss would not exceed a certain amount or threshold at a given confidence level—for example, 95% or 99% of the time—for a defined period of time. VaR failed to model what could happen beyond that confidence level, an event known as tail risk. The Basel Committee has suggested that VaR be replaced with the expected shortfall approach to risk measurement. The committee agreed to use the 99th percentile for expected shortfall; it is not a perfect measure but, rather, one of many tools. It appears that the expected shortfall approach is only an enhanced version of VaR and that it suffers from similar drawbacks.

Given the limitations of financial models such as these, the authors propose an alternative approach to measure capital adequacy. Not only can accounting disclose an enterprise’s financial condition, but also it can be adapted to reveal the risks the company may be subject to by adding information to the transactions that it enters into. Regulators could then use financial statements to monitor risk as part of an auditable process. Investors could make use of a tool to compare risk exposures both within and across institutions.

How Did the Authors Conduct This Research?

The authors review the Basel Committee’s revisions to the market risk framework and its review of the trading book, noting the committee’s reservations about the adequacy of VaR to measure potential losses in a financial institution’s capital adequacy. They question whether the proposed replacement of VaR with the expected shortfall approach will better capture the effect of extreme events on a firm’s capital buffers. Although one could argue that expected shortfall is a more robust methodology than VaR, it still has the same limitation that the outcomes are not clear in what they represent.

Accounting can be adapted to identify potential risk exposures in various transactions as reflected on the balance sheet and income statement. As such, the practice can serve as an important risk reporting tool that could benefit regulators, investors, and stakeholders.

Abstractor’s Viewpoint

The extent to which a financial institution is financially strong is a function of its business lines and the transactions it enters into. Proponents of risk modeling deal in “what if,” which is useful to a point but often deficient, as the financial crisis has made clear. In contrast, practitioners of financial accounting address the “what is” by uncovering the truth reflected on the balance sheet and income statement, which reveal a company’s true financial condition and the risks attached to it. The authors succinctly highlight the ongoing importance of financial accounting as a critical skill in the toolbox of financial analysis. Financial risk managers and students of forensic accounting should carefully consider the authors’ conclusions.

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