Corporate Governance, Greed and Leverage

Defending VAR - But You Still Need Common Sense

I am a risk manager. I use VaR (parametric, historical scaled to the VIX, and Monte Carlo) combined with scenario analyses. I also use Conditional VaR/Expected Shortfall. Importantly, I back test static daily P&L against the VaR forecasts to ensure robustness. Over the past two years of perhaps the most volatile markets we have seen that the breaches/exceptions/ut... of VaR fell with in statistical expectation. This was all overlaid with a good dose of common sense risk management, i.e. what are my concentrations, what are my exposures, leverage levels, etc. Furthermore, when stop losses are breached, we held firm and cut losses completely or reduced our exposures. This led to keeping our maximum drawdown very low and our returns positive throughout 2008.

The real problem is not the risk models....it was the leverage and greed throughout the financial system that went unchecked due to poor CORPORATE GOVERNANCE and lack of transparency. Rating agencies and investment banks were in bed together. Tons of risk managers using both quantitative and qualitative risk tools unearthed plenty of evidence that sounded an alarm that sub-prime was a problem waiting to happen, but their voices were drowned out by greedy traders and ignored by senior management who were too concentrated on soaking up fat short-term returns with complete disregard for the sh*tstorm waiting to hit just around the corner.

Bank Risk: Will Basel II Finally Discredit VAR?

While VaR undoubtedly has its limitiations, this author is focusing purely on simple Gaussian parametric VaR which looks at historical offsetting correlations among asset returns and assumes normality of distributions. Normailty only tends to hold for delta-1 products with linear payoff functions such as cash equities, CFDs, swaps, futures, etc. When it comes to products with non-linear payoff fucntions and consequently non-normal return distributions such as options, structured products (ABS, CLNs, CDOs, etc.), prepayment on loans, contingent liabilities, etc., pararmetric VaR will grossly underesimate risk. Second, I would hope most practitioners are keenly aware that VaR does not capture liquidity risk. It simply captures market risk factors such as fx, equity, vol, ir, etc. Some models also incorpate credit VaR. For liquidity risk, you would need to calculate a completely set of different measures.

Therefore, it is no wonder why when markets fully correlate in downturns and liquidity dries up that your VaR figure will not work. That is why there is always the caveat that VaR only works in "normal market conditions". For this reason, this is is why we should not only use VaR, or believe everything the VaR number has to say. We should look at stress testing and scenario analysis as well.

To use VaR for risk capital allocation is admittedly dangerous, and with levarage and easy money these models were abused when capital was allocated over the past decade. There should be a buffer on top of the VaR figure. For instance, if VaR (usning historical Monte Carlo with volatilty scaling and decay factors ajdusted to represent the current market more accurately) as a % of risky assets is 10% then maybe we should hold a buffer of reserve capital twice that (that was an aribtrary suggestion but you get the point).

I am interested to see the VaR back-testing results the author refers to in Pillar III. In this way, we will see if the VaR models held up and were robust enough. Although in this market it is easy to say they didn't. But that is not necessarily because VaR is at fault. It is because banks either misused or minunderstood how to implement VaR and viewed VaR as the de facto measure of risk instead of using it as a means to get a rough idea about the possible risks being undertaken. The confidence levels of 99% 95% are misleading and seem to suggest that VaR is quite certain of the risks. Well, VaR is certain of certain kinds of risks, just not good at measuring leverage and liquidity, which is what bit us all in the ass in the end.

In closing, VaR should not be consirdered an absolute measure of risk but simply be used in relative terms to compare across banks assuming if banks ever implement consistent and comparable VaR frameworks, which is unlikely. Further, for risk capital allocation, we should put a buffer on top of what VaR tells us and not use the VaR number itself as a direction indication of how much cash to put aside or how much risk to take.