infonet-economy

We study capital requirements when the bank's econometric model only approximately describes the dynamics of portfolio returns—which is virtually always the case in practice. We derive a simple formula for capital requirements based on a first-order Taylor expansion of the Value at Risk around a ‘model confidence’ parameter. This formula allows to reflect the bank's confidence in the econometric model into capital requirements in a theoretically consistent manner. Numerical and empirical applications show that our formula provides valuable information for quantifying capital requirements under model risk.