PM could flag website to fix risk holes

Published in The Australian Financial Review

In “Bad risk mismanagement, not VaR” (Letter, October 23) Frank Ashe defends the banking industry risk measure standard VaR (Value at Risk) and blames the crisis on bad risk management. He then lists a comedy of risk management errors behind the UBS $US37 billion debacle. I doubt the same comedy of errors explains the silence of all bank boards, regulators and academics before the risk bomb exploded.

Published cartoon - AFR - 27 Oct 2008

Of course it was bad risk management. Risk management has three aspects, 1. risk measurement, 2. risk reshaping and 3. getting the first two right. Frank Ashe’s list of UBS errors fits nicely into point 3. Had the UBS risks been measured properly and transparent their massive risks would not have survived long enough to be mis-managed. At least one of the UBS board, its shareholders or its regulators would have moved like lightning to close the risk holes.

This is why I say the real root cause of the banking crisis was poor risk measurement, VaR. It’s the reason why bankers, regulators, investors, analysts and academics were caught out en masse and silent before the risk bomb exploded. The risks were not seen because the industry risk standard VaR hides catastrophic risks. Imagine cars built with speed meters that show variable measures for the same speed and never a speed over 60 KPH. The law on speed limit would be meaningless. VaR is the variable risk meter for banks. Two banks can report the same VaR – one may be safe, the other destined to crash.

I invite Prime Minister Kevin Rudd to take to the November 15 G-20 financial summit the idea from Australia that a website be established where all banks must report daily their exposure to wide ranging movements in all the economic variables to which they are exposed. The academics might like to show how such a website would have appeared over the last decade, including the VaR measures as a comparison. Add to this a permanent online global opinion market that harvests ideas from risk experts and ranks them live with democratic voting for all to see.

Published version – AFR – 27 Oct 2008

Bankers, regulators caught out

Published in The Australian Financial Review

As author of the book Risk Mechanics, financial derivatives, finding and fixing risk holes, and a long term critic of VaR (Value at Risk), I view it as a very positive sign that a debate is emerging on the way banks measure and report risks. Failures of risk measurement and reporting are the real root cause of the banking crisis. In “Risk measure’s complex frame” (letters October 20) Frank Ashe defends the role of VaR as a risk measure while acknowledging VaR has shortcomings that need to be augumented by stress testing.

So why were so many conservative bankers and regulators caught out by the explosion of a massive risk bomb? The only possible explanation is that the risk stakeholders, regulators and academics believed the risks were known and not extreme. Nothing else can explain the number of conservative institutions that invested heavily in the risky subprime instruments or the silence of regulators and others before the risk bomb exploded. The few whistle blowers were ignored.

The risk bomb was created by Wall Street investment bankers because, as a risk measure, VaR thinking dominated over rigourous stress testing. VaR is the perfect risk measure if the objective is to make risky investments look safe, hide the potential for catastrophic loss and give the illusion that capital requirements are far below that needed to match the real exposure. Senior managers, investors and regulators alike felt relaxed and comfortable with a risk measurement process with a name like “Value at Risk” unaware that the actual value at risk may be vastly greater than indicated.

An engineer would never build a structure based on a risk measure that emulated the simplistic single statistic, naive risk measure of VaR. Robust stress testing might appear more complex and less elegant. However it ensures that all unacceptable risks are seen and therefore avoided or reshaped. VaR failed absolutely. It’s part of the history of Wall Street banks. It deserves no place in the future.

Published version - AFR - 21 Oct 2008

Risk measure failed

Published in The Australian Financial Review

The federal government has moved to guarantee bank deposits with tax payer resources. What is the Government going to do about the failed banking industry risk measurement standard with the highly misleading name, Value at Risk (VaR)?  This is the real root cause of the systematic banking failures emanating from Wall Street.
 

Published version- AFR - 15 Oct 2008

Why were voices of reason on risk ignored in the US?

Published in The Australian Financial Review

Many myths are circulating about the root cause of the crisis in financial markets created by Wall Street. The root cause was none of securitization, the housing price collapse, predatory lending, free markets, short selling, innovation or borrowing short lending long. Not even greed, regulation or lack of it was the direct cause. Sound risk management can cope with all these simultaneously.

Risk management relies on accurate measurement of risk. If the risk is not measured and seen it cannot be managed. The root cause of this crisis was announced in 1996 in a report published in Euromoney’s Corporate Finance. The report exposed a devastating flaw in a risk measurement method called VaR (Value at Risk) imposed on the financial markets by Wall Street. I was the report’s author. It warned that widespread reliance on VaR left the financial markets exposed to a risk Tunguska, as I called it. Named after a massive aerial explosion 8km above Eastern Siberia on June 30, 1908 which devastated 500,000 acres. My point was to emphasis the seriousness of the problem, now exploded closer to home in 2008. I published many other papers in the 90s on the same theme including the book Risk Mechanics, finding and fixing risk holes.

VaR hides the many complexities of market risk. In particular, it ignores elements of risk associated with catastrophic loss. Yet, in the 1990s, Wall Street “rocket scientists” aggressively marketed VaR establishing it as the accepted standard of market risk measurement.

Imagine a fruit and veg trader from main street attempting to value a concealed bag of fruit and veg by its weight only. He has no idea if the bag contains potatoes, a mixed bag or bad apples. The single statistic of weight alone does not enable the fruit and veg trader to price the bag or understand the risk of holding it. Yet VaR is every bit as naive as the fruit and veg trader attempting to value his investment on weight alone. Less is not always more.

A long term solution to this crisis must answer why so many investment banker “rocket scientists” embraced a risk measurement method as naive as VaR. Why were voices of reason ignored? Whatever the motive, the rise of VaR made it easy to sell financial instruments with catastrophic elements in their payoffs. Promoters of these instruments are rewarded on a time scale much shorter than the expected time scale of these catastrophes.

Senior managers and regulators felt relaxed and comfortable with a risk measurement process with a name like “Value at Risk”. As the volume of financial instruments with hidden but massive risk holes ballooned the day of reckoning in the financial markets, the risk Tunguska, was inevitable.

Published version - AFR - 6 Oct 2008