By multiplying the VaR output, the aim is to provide a cushion against potential weaknesses in the model itself as well as some cover over and above the confidence level (e.g. 99%) used. Furthermore, the VaR output is the estimated maximum loss at a certain confidence level and in a given holding period. In reality, this level of loss might occur more than once in a short period of time.

Pros

• The multiplier covers potential weaknesses of the modelling approach such as fat tail issues.
• Multipliers are used by some firms to manage their market risk internally.
• Simple.
• Emphasises the relative riskiness of products (i.e. it loads significantly more capital onto riskier products).

Cons

• A multiplier might encourage firms that would otherwise take a conservative approach to calculating VaR to be less conservative in order to reduce the impact of the multiplier. The multiplier might therefore be a perverse incentive to design a model to minimise regulatory effects rather than optimise its use as a risk management tool.
• A low initial number from a flawed model will not be corrected by a multiplier.
• The particular multiplier chosen is open to the charge that it is arbitrary.

(ii) Add-on Based on Stress testing

Another approach would be to use VaR plus an add-on that reflects, in some fashion, the simulation of extreme market movements, including the breakdown of correlations and other assumptions.

Pros

• Risk based.
• Can capture liquidity and fat tail risks.
• Can provide a flexible tool to re-inforce supervisors' qualitative approach.

Cons

• It gives firms an incentive to tailor their stress testing to meet supervisory requirements.
• It is difficult to establish a consistent approach to the calculation of the add-on.