What is a requirement for internal capital in relation to VAR?

The requirement for internal capital in relation to Value at Risk (VaR) is grounded in the need for financial institutions to hold sufficient capital to absorb potential losses. When considering the relationship between internal capital and VaR, especially at a confidence level of 1%, it is essential to recognize that this level reflects the amount of capital needed to cover potential losses that could occur in 1 year with a 99% confidence level.

By setting the internal capital to be greater than or equal to the 1-year aggregate VaR at 1%, institutions ensure that they have a cushion against adverse market movements, thus providing a buffer for unexpected losses beyond the 99th percentile threshold. This requirement acknowledges that while VaR is a useful measure of risk, it does not account for all tail risks or extreme market events. As a result, holding capital at least equal to this VaR level helps promote financial stability and resilience, aligning with prudent risk management practices.

In addition, this approach allows institutions to maintain capital adequacy and operate within regulatory frameworks that may target capital levels tied to risk metrics like VaR.