By Xavier Bellouard,
co-founder at Quartet FS
Following the collapse of Lehman Brothers two years ago, risk, and particularly market risk, has become the buzzword in the banking and investment world. Its presence has grown following the industry’s realisation that the lack of risk management was arguably the root cause of the financial crisis. Risk models did not reflect accurately enough the potential problems and correlations within investments and while almost all aspects of life in the financial world have evolved in the past 60 years, many aspects of risk models have remained unchanged.
This lack of foresight and resultant market turmoil has since forced industry bodies to address risk modelling and introduce stricter governance in an effort to better understand a bank’s risk exposure. In 2009-10 the FSA stepped up its regulation of the industry, issuing a record number of fines and eclipsing the levels of the previous year by 21 per cent, according to a report by city law firm Reynolds Porter Chamberlain. The research suggests that the regulator handed out penalties totalling £33.1 million over the course of the year. In addition, the Basel committee is enforcing stricter capital rules and requirements with capital charges projected to treble with the introduction of Basel III. Risk management and regulation has clearly entered a new era.
In this article Xavier Bellouard, co-founder at Quartet FS, looks at what increased scrutiny means for those tasked with trying to measure market risk in the post-financial crisis world.
For financial institutions’ risk managers, the new wave of market regulation is cause for concern and is a clear wake-up call which has exposed the short fallings of current risk models. Since the 1990s investment firms have relied on highly complex mathematical models for measuring the associated risk in their various portfolios, primarily to reassure investors that all is well. While risk managers use a variety of fantastically advanced mathematical models to measure market risk, the most widely used has been Value at Risk (VaR).
VaR is built around statistical ideas and probability theories that have been around for centuries. It describes the probability of losing more than a given amount of assets, based on a current portfolio. Alongside its ability to express risk as a single number, it is the only commonly used risk measure that can be applied to just about any asset class. VaR allows banks and investment firms to make quick and simple predictions on the potential losses of trading. While its use is undeniably invaluable, its ability to estimate tail risk has been criticised ever since the worldwide financial crisis. Although its application has been extended in many ways to reflect liquidity risk and take into account operational risk and basic stop losses, it is still backward looking and can fall short if there is an extreme change in price.
With this in mind it is now necessary for risk models to evolve in order to better cope with market risk. While many argue that the current VaR model needs to be addressed, one could argue that it is more banks’ and traders’ approach to, and use of VaR, that needs to change, rather than the actual model itself. The question is how?
Firstly, VaR needs to be broken down and analysed by traders. Instead of relying on a single number, traders need to look beyond the top line and delve into the complex mathematical calculations to gain a better understanding of the type of risk they are taking and how it can best be mitigated. By taking this approach VaR will become a valuable management tool, alongside other factors, such as the Profit and Loss sheet.
Secondly, as well as better analysis, traders need to receive VaR calculations in a timely manner. When used simply as a reporting tool, receiving VaR calculations within 24 or 48 hours is adequate. However, if traders are to have the ability to act on the information provided within the VaR calculation, they require the information a lot more quickly. While, real-time VaR might not be necessary, receiving the information within the trading day is crucial. A firm’s ability to understand its risk position in near real-time can allow it to undertake more and / or greater positions and trade across complex products with more confidence.
As we know many of these considerations are currently being mandated by the regulators.
It is expected that the emerging regulations will not only require a change of culture but also a review of banking systems. As it stands, many financial institutions simply do not have the right technology in place to deliver in-depth VaR analysis in a timely fashion.
A lack of sophisticated technology within banks sits at the heart of the risk management problem. In general, banks are no better prepared now for another financial meltdown than they were prior to the recent recession. This is not necessarily down to complacency but more due to the fact that financial institutions have not had long enough to implement new risk management methods and make the necessary changes to their IT infrastructure. Faced with pressure from the regulators, IT projects are underway, but the overall results and improvements are still a few years off.
Looking at VaR in particular, the Basel committee is modifying its Internal Model Approach to assessing regulatory capital for market risk by introducing a “Stressed VaR” charge”(1.), and an increasing proportion of financial institutions are supplementing the use of VaR results with stress tests when reviewing their allocation of economic capital. New rules such as this will take time for financial institutions to digest and respond to. However, once banks do have enhanced risk management systems in place, they should pay dividends. For example, when VaR is supplemented by well-designed stress tests, the resulting risk estimates incorporate traditional market risk and the outcomes of stress tests, as well as the probabilities of each. They therefore give risk managers a single, integrated set of risk estimates to work with.
To conclude, over the course of the next few years investment firms will have to get to grips with new regulatory requirements, a necessary condition to avoid another financial disaster. This will mean embracing new technology and implementing more sophisticated risk mitigation solutions and approaches. At the end of the day, the widespread institutional reliance on models such as VaR, as an accurate indicator of market risk, is only a gamble if traders do not have the right technology solutions in place to help them analyse and break down VaR in near real-time.
1. BCBS, ‘Revisions to the Basel II market risk framework’, July, 2009