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Theoretical and Applied Economics
No. 11 / 2007 (516)

The Basel II Accord on Measuring and Managing a Bank's Risks

Ion Stancu
Academia de Studii Economice, Bucuresti
Andrei Tinca
Universitatea Webster, Viena

Abstract. The abundance of risk metrics stems from the effort to measure the difference between the expected and actual returns, under a hypothesis of normality. Under the assumption of risk aversion, investors are likely to quantify risk using metrics which measure returns lower than the expected average. These include the semi-variance of returns smaller than the average, the risk of loss – a return under a chosen level, usually 0%, and value-at-risk, for the greatest losses, with a probability of less than 1-5% in a given period of time. The Basel II accord improves on the way risks are measured, by allowing banks greater flexibility. There is an increase in the complexity of measuring credit risks, the market risks measurement methods remain the same, and the measurement of operational risk is introduced for the first time. The most advanced (and widely-used) risk metrics are based on VaR. However, it must be noted that VaR calculations are statistical, and therefore unlikely to forecast extraordinary events. So the quality of a VaR calculation must be checked using back-testing, and if the VaR value fails in a percentage of 1-5% of the cases, then the premises of the model must be changed.

Keywords: Risk; Value-At-Risk; Basel II; Capital Adequacy; Monte-Carlo Simulation.

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