Duration Risks of Value-at-Risk

Abstract

Since borrowers want minimal pressure to repay early while depositors want minimal constraints on withdrawals, banks typically borrow short to lend long. This is known as duration mismatch. To mitigate the risks, banks are required to hold capital buffers, which are intended to cover all losses from default nearly all of the time. A favored threshold is 99.9% per year, or one breach expected per thousand years. The capital needed to provide this protection is known as Value at Risk or VaR.

Unfortunately, major breaches of VaR occur far more often than standard models predict. The latter focus too much on outliers given static risks and not enough on the possibility that risks themselves are perceived to surge. For long duration credit bonds, the markdowns on pessimistic shifts in expectations can greatly outweigh the direct impact of a spurt in defaults.

Standard capital buffers cannot reliably cover these markdowns. Readjusting buffer requirements to duration and forecasts of future risks is fraught with estimation error and bound to induce regulatory arbitrage. The simplest remedy with the least moral hazard would limit duration mismatch.