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Unexpected shortfalls of expected Shortfall: Extreme default profiles and regulatory arbitrage


Koch-Medina, Pablo; Munari, Cosimo-Andrea (2016). Unexpected shortfalls of expected Shortfall: Extreme default profiles and regulatory arbitrage. Journal of Banking and Finance, 62:141-151.

Abstract

The purpose of this paper is to dispel some common misunderstandings about capital adequacy rules based on Expected Shortfall. We establish that, from a theoretical perspective, Expected Shortfall based regulation can provide a misleading assessment of tail behavior, does not necessarily protect liability holders’ interests much better than Value-at-Risk based regulation, and may also allow for regulatory arbitrage when used as a global solvency measure. We also show that, for a value-maximizing financial institution, the benefits derived from protecting its franchise may not be sufficient to disincentivize excessive risk taking. We further interpret our results in the context of portfolio risk measurement. Our results do not invalidate the possible merits of Expected Shortfall as a risk measure but instead highlight the need for its cautious use in the context of capital adequacy regimes and of portfolio risk control.

Abstract

The purpose of this paper is to dispel some common misunderstandings about capital adequacy rules based on Expected Shortfall. We establish that, from a theoretical perspective, Expected Shortfall based regulation can provide a misleading assessment of tail behavior, does not necessarily protect liability holders’ interests much better than Value-at-Risk based regulation, and may also allow for regulatory arbitrage when used as a global solvency measure. We also show that, for a value-maximizing financial institution, the benefits derived from protecting its franchise may not be sufficient to disincentivize excessive risk taking. We further interpret our results in the context of portfolio risk measurement. Our results do not invalidate the possible merits of Expected Shortfall as a risk measure but instead highlight the need for its cautious use in the context of capital adequacy regimes and of portfolio risk control.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:January 2016
Deposited On:06 Jan 2017 14:34
Last Modified:07 Jan 2017 04:08
Publisher:Elsevier
ISSN:0378-4266
Publisher DOI:https://doi.org/10.1016/j.jbankfin.2015.11.006
Related URLs:http://www.sciencedirect.com/science/article/pii/S0378426615003064 (Publisher)
Other Identification Number:merlin-id:12493

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