Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition

Chapter 10

Other Major Risk Classes

The recognition of major risk classes by the Basel Committee for inclusion into the regulatory capital regime has been the driving force for the development of their risk models. The original Basel I Accord (1988) focused on credit risk, which is by far the largest risk class faced by banks. An Amendment (1996) included market risk into the capital regime and introduced the “internal models” approach (by de facto value at risk, or VaR). The Basel II reform (2004) established operational risk as a major risk, following the fall of Enron and WorldCom, two of the largest corporate bankruptcies caused by unauthorized trading and accounting scandal. The 2008 credit crisis highlighted two other risk classes that were overlooked—firm’s liquidity risk and counterparty credit risk. These are addressed in Basel 2.5 rules (in 2009), which were subsequently subsumed into Basel III (in 2010). This chapter gives a brief overview of risk classes (other than market risk) and the conventional models used to quantify them before Basel III. In the next chapter, we look at the new models of Basel III.

From a regulatory capital perspective, one challenge is in aggregating these diverse classes of risk—credit, market, operational, counterparty, and liquidity. This so-called problem of aggregation to merge the various risks under a unified theory has attracted much interest from academics. The last section addresses the challenges of aggregating these very different ...