The internal models amendment to the Basel Accord allows banks to use internal models to
forecast Value-at-Risk (VaR) thresholds, which are used to calculate the required capital
that banks must hold in reserve as a protection against negative changes in the value of
their trading portfolios. As capital reserves lead to an opportunity cost to banks, it is likely
that banks could be tempted to use models that underpredict risk, and hence lead to low
capital charges. In order to avoid this problem the Basel Accord introduced a backtesting
procedure, whereby banks using models that led to excessive violations are penalised
through higher capital charges. This paper investigates the performance of five popular
volatility models that can be used to forecast VaR thresholds under a variety of
distributional assumptions. The results suggest that, within the current constraints and the
penalty structure of the Basel Accord, the lowest capital charges arise when using models
that lead to excessive violations, thereby suggesting the current penalty structure is not
severe enough to control risk management. In addition, an alternative penalty structure is
suggested to be more effective in aligning the interests of banks and regulators.
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