Economic Capital for Market Risk

The interaction of capital and risk for trading and treasury units is of primary interest in the corporate governance of banks as it links operational profitability and strategic risk management. During the financial crisis, several banks' trading units suffered significantly higher losses than their risk capital charged based on value-at-risk constraints. There is a structural inconsistency between strategic risk management with a one-year internal capital adequacy assessment process and operating risk management with a ten-day risk horizon for trading units.A new risk budgeting scheme aligns bank risk appetite on an annual basis with operating short-term risk limits. A bank assigns an annual risk budget to its market risk managers. The annual risk budget equals the probability of an annual loss that is higher than a predefined capital-at-risk. Managers' risk consumption equals the probability of a year-to-date loss in excess of the capital-at-risk at the 10-day risk horizon. As soon as the risk manager has completely consumed his annual risk budget, he immediately has to hedge his positions. The more risk a manager takes and consumes today, the more likely he will be restricted in the future. This relation forces the risk taker to run market risk in a conscious and far-sighted manner