The Basel 2.5 capital regulatory framework and the COVID-19 crisis: evidence from the ethical investment market

Abstract

PurposeThis research aims to evaluate the accuracy of several Value-at-Risk (VaR) approaches for determining the Minimum Capital Requirement (MCR) for Islamic stock markets during the pandemic health crisis.Design/methodology/approachThis research evaluates the performance of numerous VaR models for computing the MCR for market risk in compliance with the Basel II and Basel II.5 guidelines for ten Islamic indices. Five models were applied—namely the RiskMetrics, Generalized Autoregressive Conditional Heteroskedasticity, denoted (GARCH), fractional integrated GARCH, denoted (FIGARCH), and SPLINE-GARCH approaches—under three innovations (normal (N), Student (St) and skewed-Student (Sk-t) and the extreme value theory (EVT).FindingsThe main findings of this empirical study reveal that (1) extreme value theory performs better for most indices during the market crisis and (2) VaR models under a normal distribution provide quite poor performance than models with fat-tailed innovations in terms of risk estimation.Research limitations/implicationsSince the world is now undergoing the third wave of the COVID-19 pandemic, this study will not be able to assess performance of VaR models during the fourth wave of COVID-19.Practical implicationsThe results suggest that the Islamic Financial Services Board (IFSB) should enhance market discipline mechanisms, while central banks and national authorities should harmonize their regulatory frameworks in line with Basel/IFSB reform agenda.Originality/valuePrevious studies focused on evaluating market risk models using non-Islamic indexes. However, this research uses the Islamic indexes to analyze the VaR forecasting models. Besides, they tested the accuracy of VaR models based on traditional GARCH models, whereas the authors introduce the Spline GARCH developed by Engle and Rangel (2008). Finally, most studies have focus on the period of 2007–2008 financial crisis, while the authors investigate the issue of market risk quantification for several Islamic market equity during the sanitary crisis of COVID-19.