Back-testing of Expected Shortfall: Main challenges and methodologies

Following recent financial crises and their disastrous impacts on the industry, regulators are proposing tighter monitoring on banks so that they can survive in extreme market conditions. More recently, the BCBS announced a change in the Market Risk measure used for Capital requirements in its Fundamental Review of the Trading Book (FRTB), moving from the Value-at-Risk (VaR) to the Expected Shortfall (ES).

However, if the ES captures risks more efficiently than the VaR, it also has one main downside which is its difficulty to be back-tested. This leads to a situation where banks use the ES to perform Capital calculations and then perform the back-testing on a VaR. The focus for banks’ research is now to try to find ways to back-test using the ES, as it can be expected that regulators will require so in a near-future.

This white paper aims at presenting the latest developments in the field of ES back-testing methodologies and introducing new methodologies developed by the Global Research & Analytics (GRA) team of Chappuis Halder & Co.