Value at Risk : Concept and it's Implementation for Indian Banking System

Value-at-Risk (VaR) has been widely promoted by the Bank for International Settlement (BIS) as well as central banks of all countries as a way of monitoring and managing market risk and as a basis for setting regulatory minimum capital standards. The revised Basle Accord, implemented in January 1998, makes it mandatory for banks to use VaR as a basis for determining the amount of regulatory capital adequate for covering market risk. For market participants like Banks and Primary Dealers (PDs) in the Indian financial sector, it has become imperative to use VaR methods to calculate the regulatory capital charge required. The RBI has issued guidelines for PDs. We have adopted three categories of VaR methods, viz., Variance-Covariance (Normal) methods including Risk-Metric, Historical Simulation (HS) and Tail-Index Based approach. The Zero-Coupon Yield Curve (ZCYC) compiled by National Stock Exchange (NSE) has been used to price the bonds as well as portfolios. Estimated VaRs are validated by carrying out quot;back testingquot; based on last one year's data. Empirical results show that normal methods, in particularly the Risk-Metric approach, underestimate VaR numbers substantially resulting to too many failures in backtesting. Historical simulation provides more accurate VaR estimates, and indicates capital charge higher than those obtained through normal methods. The tail-index (Hill's estimator) based method also perform quite well though at times it provides too conservative VaR estimates - higher than all other competing VaR models considered here and occasions of VaR violation in backtesting are less than expected number for each bond/portfolio