Module: | MODULE B: RISK MANAGEMENT
Q312: Scenario: A bank uses the Internal Models Approach (IMA) for Market Risk. Over a quarter, the regulator observes multiple backtesting exceptions where actual trading losses frequently exceeded the bank's daily Value at Risk (VaR) estimates. Based on the Basel II framework, consider the following statements regarding the regulatory response:
1. The regulator will immediately force the bank to switch back to the Standardised Duration Approach.
2. The regulator will mandate an increase in the multiplication factor applied to the VaR estimate to calculate capital.
3. The backtesting process strictly involves comparing daily VaR predictions against actual daily trading outcomes.
Which of the statements given above is/are correct?
2. The regulator will mandate an increase in the multiplication factor applied to the VaR estimate to calculate capital.
3. The backtesting process strictly involves comparing daily VaR predictions against actual daily trading outcomes.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is incorrect: A poor backtesting result does not automatically and immediately force a bank to revert to the Standardised Duration Approach (SDA), though it is an extreme last resort.
Statement 2 is correct: The standard regulatory response to repeated backtesting exceptions (where actual losses exceed the VaR estimates) is to apply a supervisory "plus factor" penalty.
This increases the standard multiplication factor (usually set at 3) up to a maximum of 4, significantly raising the capital the bank must hold.
Statement 3 is correct: Backtesting is explicitly defined as the process of comparing the daily VaR measure generated by the internal models against the actual daily changes in portfolio value (trading outcomes) to validate model accuracy.
Statement 2 is correct: The standard regulatory response to repeated backtesting exceptions (where actual losses exceed the VaR estimates) is to apply a supervisory "plus factor" penalty.
This increases the standard multiplication factor (usually set at 3) up to a maximum of 4, significantly raising the capital the bank must hold.
Statement 3 is correct: Backtesting is explicitly defined as the process of comparing the daily VaR measure generated by the internal models against the actual daily changes in portfolio value (trading outcomes) to validate model accuracy.