Market risk management in a post-Basel II regulatory environment

• Published in: European journal of operational research Vol. 257; no. 3; pp. 1030 - 1044
• Main Authors: Drenovak, Mikica, Ranković, Vladimir, Ivanović, Miloš, Urošević, Branko, Jelic, Ranko
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 16.03.2017; Elsevier Sequoia S.A
• Subjects: Algorithms; Basel 2.5; Capital requirements; Finance; GARCH; Market risk; NSGA-II; Optimization; Pareto optimum; Studies; Volatility; NSGA-II; Basel 2.5; GARCH; Finance; Market risk
• ISSN: 0377-2217; 1872-6860
• DOI: 10.1016/j.ejor.2016.08.034

•We propose a novel method of Mean-Capital Requirements (CR) portfolio optimization.•Our large-scale optimization framework combines NSGA-II algorithm and R software.•Obtained optimal portfolios are not penalized by Basel 2.5 regulation.•Stressing original correlations of asset returns improves Mean-CR tradeoffs.•Improvements are related to reductions in cardinality of optimal portfolios. We propose a novel method of Mean-Capital Requirement portfolio optimization. The optimization is performed using a parallel framework for optimization based on the Nondominated Sorting Genetic Algorithm II. Capital requirements for market risk include an additional stress component introduced by the recent Basel 2.5 regulation. Our optimization with the Basel 2.5 formula in the objective function produces superior results to those of the old (Basel II) formula in stress scenarios in which the correlations of asset returns change considerably. These improvements are achieved at the expense of reduced cardinality of Pareto-optimal portfolios. This reduced cardinality (and thus portfolio diversification) in periods of relatively low market volatility may have unintended consequences for banks’ risk exposure.