PnL VaR – Drivers and Implications

Blog Financial Services

When discussing PnL VaR, we refer to the implication profit and loss calculations of an enterprise, mostly financial institutions, on its value at risk measures. This data is used to provide an estimate of the amount of economic capital the enterprise believes is needed to absorb potential losses that are associated with each of the risks it faces.

The drivers behind the implementation of PnL VaR are the most recent amendments to the Basel Accord following the global economic crisis in 2008. The Basel Accord is a set of agreements set by the Basel Committee on Bank Supervision (BCBS) that provide recommendations on banking regulations with respect to capital risk, market risk and operational risk. The purpose is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

The first Basel Accord, or Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk divides the assets of a financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less.

The second Basel Accord, or as Basel II, focuses on three main areas, including minimum capital requirements in relation to credit risk, operational risk and market risk, supervisory review and market discipline. These are known as the three pillars, and they are intended to strengthen international banking capital requirements, as well as to supervise and enforce these requirements. Basel II promoted the implementation of VaR measures to assess market risk.

The third of the Basel Accords, Basel III, was developed in response to deficiencies in financial regulation that were revealed by the 2008 global financial crisis, and following the collapse of Lehman Brothers bank. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and leverage. Some of the purposes behind Basel III is to promote better-integrated management of market and counterparty credit risk, adding CVA (credit valuation adjustment) risk due to deterioration in counterparty’s credit rating, strengthen capital requirements for counterparty credit exposures arising from banks’ derivatives and raising the capital buffers backing these exposures.

Following Basel II and III, the basic idea behind VaR measures is to analyze the statistical properties of different scenarios, or profit and loss scenarios to calculate and reach an estimated minimum capital that is required to put aside as a safety net.

The recent amendments in the Basel Accord have two main implications. First, strengthening the regulatory framework, as the regulator requires a high VaR confidence level, which affects financial institutions’ CVA risk. This in turn contributes to PnL VaR, which in reality means greater profit and loss stability, a great advantage to any business.

The need to keep up with the evolving regulatory requirements and increased need to monitor, measure, and report requires financial institution to have the ability to measure risk exposures in real time, especially in relation to counterparty risk and profit on loss implications on VaR. We have developed the ActivePivot system to provide solutions that address these financial needs.

Our ActivePivot system, an object-based, in-memory, real time OLAP solution, provides capabilities to integrate complex VaR calculations such as future exposures and dynamic credit value adjustments (CVA), as well as complex netting and collateral rules. Additionally, ActivePivot counterparty risk management solution can run simulations to assess the impact of various risks and business strategies on profit and loss in real time.

To try out ActivePivot’s Value at Risk solution analytics, see our live demo.