MSCI develops methodology to backtest Basel Committee-mandated Expected Shortfall calculation

Source: MSCI

a leading provider of investment decision support tools worldwide, announced today that it has developed a methodology to backtest Expected Shortfall, a risk measure that has been proposed by the Basel Committee on Banking Supervision as an alternative to Value at Risk (VaR).

In 2012, the Basel Committee proposed as part of its first consultative paper Fundamental Review of Trading Book Capital Requirements to change the measurement method for calculating losses from the method of Value at Risk - a metric banks have used since 1996 to calculate regulatory capital requirements - to an alternative known as ‘Expected Shortfall’ which regulators believe will better capture the extreme losses that can occur in times of systemic turmoil. However, a key concern with using Expected Shortfall has always been that, unlike Value at Risk, it cannot be backtested due to a theoretical debate around its mathematically property called elicitability. Because of this debate, in its second consultative paper in October 2013, the Basel Committee suggested adopting Expected Shortfall to measure risk, but continuing to backtest using Value at Risk.

New groundbreaking research from MSCI solves this dilemma by demonstrating that it is not only possible to backtest Expected Shortfall, but that the methodology MSCI has created is a more informative test of model performance than the current Value at Risk backtesting methodology.

“This exciting development from MSCI’s research team is another example of our focus on innovation and serving the needs of the Risk office,” said Jorge Mina, Managing Director at MSCI. “Now that we have established that Expected Shortfall can be backtested, we can remove this issue from the debate and focus on how firms can best capture tail risk and hence help strengthen capital standards for market risk.”

The soon to be published paper Backtesting Expected Shortfall by Carlo Acerbi, PhD and Executive Director at MSCI and Balazs Szekely, PhD and Senior Researcher at MSCI, is one of many produced by MSCI’s 150+ strong research team - one of the largest research organizations in the industry. As well as publishing proprietary applied and model research, MSCI has also been commissioned by some of the world’s largest investors to carry out research on areas such as factor investing.

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