[R-SIG-Finance] Capital requirements as a cushion against risks, why?

R. Michael Weylandt <michael.weylandt@gmail.com> michael.weylandt at gmail.com
Sat Aug 3 17:06:15 CEST 2013



On Aug 3, 2013, at 9:06, Copula Guy <copulaguy at yahoo.de> wrote:

Didn't Dirk ask you to use your real name?

> I am currently programming different VaR models with R and I often read about the Basel framework. There the capital requirements are determinded by a fomula which uses the VaR. Now I am wondering, why a bank needs to hold a certain amount of capital? 
> 
> 
> In general, it says, the minimum capital requirements are used, to 
> determine the capital that banks must hold as an insurance against risk.
> E.g. if a Bank has invested in one equity asset, e.g. Microsoft stock (long). If now the stock drops, the bank's asset looses value - so the 
> bank has a loss, but it does not have to actually PAY something? Why 
> should the bank hold extra money as an insurance against this drop in 
> the assets value?
> 

But you're ignoring the bank's other side: where did the initial cash come from? In the simplest scenario, it originated in someone's deposit account and they can ask for it back. In normal times, the bank can sell part of their investment and give the cash back to the depositor.  If the bank has lost the cash on a failed investment, they can't fulfill their obligation to a customer which is considered, not surprisingly, a very bad thing. How would you feel if your bank lost the money in your savings account? 

In practice, this all gets more complicated when you look a modern financing and leverage techniques, but that's a bit of intuition. 

> Although this is not directly a question about R programming in finance I was wondering about this, when I did my R project.
> 

Indeed it isn't so direct your follow up questions to 1) some sort of financial discussion forum (money.stackexchange.com perhapd) or 2) me offlist if you must but 3) only after reading and making a valiant attempt to understand this on your own (perhaps by reading the Basel docs) -- it's certainly well explained across the net. 

If you're a 'real book' kind of guy check out Peter Bernstein's books. He's done some nice histories of finance. 

Michael

> Thanks a lot in advance!
> 
> 
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