An Academic Response to Basel 3.5

TLDR

Recent financial crises have exposed weaknesses in Risk‑Weighted Asset modeling, where minor model adjustments can produce large RWA shifts and similar volatility arises in Value‑at‑Risk aggregation. The article aims to illuminate methodological shortcomings and illustrate them with concrete examples. The discussion is framed around two recent regulatory documents referred to as Basel 3.5.

Abstract

Recent crises in the financial industry have shown weaknesses in the modeling of Risk-Weighted Assets (RWAs). Relatively minor model changes may lead to substantial changes in the RWA numbers. Similar problems are encountered in the Value-at-Risk (VaR)-aggregation of risks. In this article, we highlight some of the underlying issues, both methodologically, as well as through examples. In particular, we frame this discussion in the context of two recent regulatory documents we refer to as Basel 3.5.