Basel Accords and the effect on Regulatory Capital : the case for Extreme Value Theory during market crises in emerging and frontier stock markets

• Main Author: Rossignolo, Adrian Fernando
• Other Authors: Fethi, Meryem; Jackson, Peter
• Published: University of Leicester 2014
• Subjects: 332.1
• Online Access: http://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.602653

Since the late 1980s, the Basel Committee has been intending to regulate the financial sector with a view to establish common regulatory standards for the banking industry through the Basel Capital Accords. Successive crises have uncovered several flaws in those directives that were remedied enacting tougher and more sophisticated mandates, particularly regarding the calculation of the Minimum Capital Requirements after the introduction of Value-at-Risk as the official measure to quantify market risks. However, Basel regulations have, in many respects, been incapable to forestall the adverse effects that market turmoil exerts on the banking system. The present thesis aims at analysing the MCR scheme employing the former Basel II and the current Basel III Capital Accords applying the VaR-based Internal Model Approach and the Standardised Approach through a variety of specifications in times of crisis using a sample of Emerging and Frontier stock markets. The findings detected structural glitches in the configuration of the Basel’s MCR formula, given the fact that both the SA and many inaccurate VaR models are allowed to compute MCR. Furthermore, there is clear evidence of the superiority of the Extreme Value Theory to calculate an adequate capital base during abrupt market swings. Basel regulations must act accordingly and reward the accuracy calibrating the extrinsic multiples and additional buffers in line with the behaviour of the models: the thesis underlines that, provided appropriate schemes had been applied, Basel II MCR would have prevented capital shortages in 2007-2008. The thesis also detects the presence of moral hazard and adverse incentives to utilise sharp models like EVT in Basel regulations and proposes a radical overhaul of the SA and a taylor-made evaluation of the parameters of the VaR-based IMA as a methodology to reward and entice the adoption of models that allow the correct estimation of market risk.