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

Tags: banking crisis, risk measurement, Risk Mechanics, Value at Risk, VAR, Wall Street, Wall Street bankers