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

[Hans Radtke]

I agree with Joshua's comment on this one. Also, this clearly isn't an R question. Which means there are other forums for this type of question, e.g. Wilmott. Also, what whith VaR already being a bit long in the tooth, conceptually, there are copious papers around explaining the genesis of this metric. Just check gloriamundis.

But actually, I'd rather rant about something entirely different: How come you're developing a flock of VaR models and don't know what they're for?! That's exactly the sort of mindset that got us into our current predicament: Modelling without any common sense! Aaaargh!

So. Anyway. *takes a deep breath*

The answer to the question is so straightforward that we might bear spelling it out: The money the bank in your example bets on a particular stock has got to come from somewhere. Let's say:

- the bankers themselves (or any other shareholders) put up $10 in equity
- deposit holders place another $90 with the bank into their (!) savings accounts
- the bank then invests the total of $100 in a single stock
- the stock drops $40, so the value of the banks assets is now $60
- sure, the bank hasn't got to pay anything just yet, but...
- the deposit holders come knocking and want to get their $90 out, as is their right
- the bankers (shareholders) are wiped out, as their $10 are gone with the wind
- the bank is broke and has to be bailed out to the tune of the remaining $30
- the deposit holders receive $60 + $30 and wonder what happened to their interest

Clearly, the equity ($10) held against what turned out to be a high-risk position wasn't quite appropriate and someone (say, both the trader and the risk manager) should be tarred and feathered.

Best regards
Hans