UiS Working Papers in Economics and Finance,
University of Stavanger

Abstract: The Basel Committee’s minimum capital requirement function for banks’ credit risk is based on value at risk. This paper performs a statistical and economic analysis of the consequences of instead basing it on expected shortfall, a switch that has already been set in motion for market risk. The empirical analysis is carried out by means of both theoretical simulations and real data from a Norwegian savings bank group’s corporate portfolio. Expected shortfall has some well known conceptual advantages compared to value at risk, primarily a better ability to capture tail risk. It is also sub-additive in gen- eral, thus always reflecting the positive effect of diversification. These two aspects are examined in detail, in addition to comparing parameter sensitivity, estimation stabil- ity and backtesting methods for the two risk measures. All comparisons are conducted within the Basel Committee’s minimum capital requirement framework. The findings support a switch from value at risk to expected shortfall for credit risk modelling.

Keywords: Expected shortfall; credit risk; bank regulation; Basel III; tail risk

JEL-codes: G10

30 pages, March 30, 2017

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