Credit Risk Modelling with Expected Shortfall - A Simulation-based Portfolio Analysis

Abstract

The Basel Committee's minimum capital requirement function for banks' credit risk is based on a risk measure called Value at Risk (VaR). This thesis performs a statistical and economic analysis of the consequences of replacing VaR with another risk measure called Expected Shortfall (ES), 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.

ES has some well known conceptual advantages compared to VaR, primarily by having a better ability to capture tail risk. ES is also sub-additive in general, so that it always reflects the positive effect of diversification. These two aspects are examined in great detail, in addition to comparing parameter sensitivity, estimation stability 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 VaR to ES for credit risk modelling.