Asset Allocation under the Basel Accord Risk Measures

TL;DR

This paper introduces a new asset allocation model that accounts for Basel Accord capital requirements, providing a practical algorithm with proven optimality and demonstrating superior performance on simulated and real data.

Contribution

It develops a unified asset allocation model incorporating Basel 2.5 and Basel III requirements, along with an efficient algorithm with theoretical guarantees.

Findings

Algorithm performs well on simulated data

Algorithm outperforms existing methods in non-convex cases

Model effectively integrates regulatory capital constraints

Abstract

Financial institutions are currently required to meet more stringent capital requirements than they were before the recent financial crisis; in particular, the capital requirement for a large bank's trading book under the Basel 2.5 Accord more than doubles that under the Basel II Accord. The significant increase in capital requirements renders it necessary for banks to take into account the constraint of capital requirement when they make asset allocation decisions. In this paper, we propose a new asset allocation model that incorporates the regulatory capital requirements under both the Basel 2.5 Accord, which is currently in effect, and the Basel III Accord, which was recently proposed and is currently under discussion. We propose an unified algorithm based on the alternating direction augmented Lagrangian method to solve the model; we also establish the first-order optimality of the limit points of the sequence generated by the algorithm under some mild conditions. The algorithm is simple and easy to implement; each step of the algorithm consists of solving convex quadratic programming or one-dimensional subproblems. Numerical experiments on simulated and real market data show that the algorithm compares favorably with other existing methods, especially in cases in which the model is non-convex.