Basel’s Traffic Light Framework for VaR Backtesting

# Rule of Traffic light


# Rule of Traffic light












I heard that there is a rule called Traffic light from Basel which is used to backtesting the VaR numbers.

However I could not find exactly which regulation from Basel mandates that, although I am overall familiar of this rule.

Could you please help me with any reference to exactly which rule first introduced the Traffic light for VaR backtesting.

Thanks for your time.

## Answer by phdstudent (score 3, accepted)

https://quant.stackexchange.com/a/76569

According to this reference:

> The back testing approach of the Basel Committee (Basel Committee for banking Basel Committee on Banking Supervision, 1996), often called the “traffic light” approach, divides the number of exceptions that a model reports into green, yellow and red zones based on a trade-off between type I and type II error assuming that the probability of observing an exception is binomially distributed. A model in the green zone is acceptable to supervisors while a model in the other two zones results in penalties imposed upon the bank. The first performance measure used in this paper is the regulatory back test prescribed by the Basel Committee (Basel Committee for banking Basel Committee on Banking Supervision, 1996). The penalty structure for the regulatory back test is as follows: $$P_t = \begin{cases} > 0 & \text{if } N \leq 4 \text{ green zone} \\ > 0.4 \text{ to } 0.85 & \text{if } 5 \leq N \leq 9 \text{ yellow zone} \\ > 1 & \text{if } N > 10 \text{ red zone} \end{cases}$$ where N refers to the number of 99% VaR exceptions over a 250 trading day time frame.

## Answer by Dimitri Vulis (score 2)

https://quant.stackexchange.com/a/81324

As @nbbo2 notes, the red, yellow (rather than amber), and green was recommended in the Basel Committee on Banking Supervision 1996 publication Supervisory framework for the use of "backtesting" in conjunction with the internal models approach to market risk capital requirements - https://www.bis.org/publ/bcbs22.pdf , pages 5-11 . However BCBS did not use the words "traffic light", which is why Google won't find it.

> It is with the statistical limitations of backtesting in mind that the Committee is introducing a framework for the supervisory interpretation of backtesting results that encompasses a range of possible responses, depending on the strength of the signal generated from the backtest. These responses are classified into three zones, distinguished by colours into a hierarchy of responses. The green zone corresponds to backtesting results that do not themselves suggest a problem with the quality or accuracy of a bank’s model. The yellow zone encompasses results that do raise questions in this regard, but where such a conclusion is not definitive. The red zone indicates a backtesting result that almost certainly indicates a problem with a bank’s risk model.

etc

Traffic light rating systems https://en.wikipedia.org/wiki/Traffic_light_rating_system are widely used not only for VaR backtesting, but for all sorts of key risk indicators, for example, indicating the data quality for various numbers on a management information report. Red-Amber-Green (RAG) is a more common color palette than Red-Yellow-Green. Sometimes there are 4 levels, rather than 3: Red-Amber-Yellow-Green. Here is a sample food label used by the Food Standards Agency in the U.K.: