Are the Basel II requirements justified in the presence of structural breaks?
The Basel Accord and the Swedish regulatory authority Finansinspektionen stipulate that banks and securities firms are obliged to estimate their Internal Risk Management Models (IRMMs) based on a minimum time series estimation period length of 1 year back in time. In this article, the Minimum Capital Risk Requirements (MCRRs) are estimated using moving windows of Swedish long and short OMX index futures positions that are bootstrapped (in blocks) by the use of Value-at-Risk Exponential Generalized Autoregressive Conditional Heteroscedasticity (VaR-(E)GARCH) models. In order to detect and adjust for structural changes in the variance, a so-called Iterative Cumulative Sums of Squares (ICSS) algorithm is applied. By the use of the earlier-mentioned approach, it is concluded that out-of-sample risk predictions are more accurate when using estimation periods shorter than 1 year, probably since relevant information are outdated fairly quickly on the markets. Therefore, the Basel Committee can discard the 1-year requirement without increased risk of financial instability.
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