Internal models lie at the heart of most risk management frameworks. They also lie at the heart of many of the problems we witnessed during the financial crisis. The use of quantitative models was taken to the absolute extreme in the modeling of trading products at major investment banks.
Their failure is now a valuable case study on why over-reliance on models can be damaging.
A new paper from the Basel Committee—who ordain banking regulations globally—calls into question the role of internal models in setting trading book capital requirements. This article looks at the likely impact of these new proposals and argues that quantitative risk analysis should continue to be the key driver of capital requirements within the trading book. Regulators should be careful not to throw the baby out with the bathwater.
