The Basel II Accord requires that banks and other Authorized Deposit-taking
Institutions (ADIs) communicate their daily risk forecasts to the appropriate monetary
authorities at the beginning of each trading day, using one or more risk models to
measure Value-at-Risk (VaR). The risk estimates of these models are used to determine
capital requirements and associated capital costs of ADIs, depending in part on the
number of previous violations, whereby realised losses exceed the estimated VaR. In
this paper we define risk management in terms of choosing sensibly from a variety of
risk models, discuss the selection of optimal risk models, consider combining
alternative risk models, discuss the choice between a conservative and aggressive risk
management strategy, and evaluate the effects of the Basel II Accord on risk
management. We also examine how risk management strategies performed during the
2008-09 financial crisis, evaluate how the financial crisis affected risk management
practices, forecasting VaR and daily capital charges, and discuss alternative policy
recommendations, especially in light of the financial crisis. These issues are illustrated
using Standard and Poor's 500 Index, with an emphasis on how risk management
practices were monitored and encouraged by the Basel II Accord regulations during the
financial crisis.
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