Copenhagen: red herring or lame duck?

Published in The Australian Financial Review

The Business Council of Australia and the Opposition Leader Malcolm Turnbull are in conflict over when the Parliament should vote on an emissions trading scheme (“Copenhagen a ‘red herring'”, 25 August). All sides are divided. Copenhagen is not a red herring but a lame duck because everyone is focused on the wrong vote.

A vote by experts is the only robust way to measure expert opinion on the science and economics of global warming. Without it no one has authority to represent the experts and the most basic questions of climate change science and economics will remain unanswered. Vested interests will determine the outcome. It may be a dangerous overreaction or expensive and useless under-reaction to the actual threat.

The public has a right, and policy makers an obligation, to really know expert opinion on the issue. And the expert opinion that matters is the current consensus of experts and its sensitivity to change. Accurate reliable measurement of this consensus is a critical bit of scientific data missing from the debate.

The IPPC attempts to be the authority on the science. However the IPCC’s measurements of scientific opinion are neither robust nor objective, regardless of intention. The use of working groups is an efficient way to condense peer reviewed scientific papers and other material into a single less technical report. However this process does not guarantee that the authors of the scientific papers endorse the IPCC reports. The process also excludes the views of many scientists qualified to comment on the published research. Without the vote doubts remain and its voice weakened.

Financial derivatives risk theory is based on robust arbitrage pricing formula. Yet the “rocket scientists” in banking led the world into an economic fire storm with an unscientific risk measure called value at risk, without real debate or a vote. Neither the climate scientists or economists have risk measurement models remotely as accurate as the financial scientists — another reason not to repeat the same errors in open debate and opinion measurement.

The Parliament should require scientists and economists to vote online before it votes. Have all relevant scientific and economic bodies invite their members to participate in a regular global and secure vote. Give every expert equal control over the voting agenda. Make the voting records, credentials and funding sources of each expert transparent. Let the vote to run continuously enabling experts to revise their votes any time. Technically there is no risk or reason to delay a vote. It could start today.

Published version - AFR - 3 Sep 2009

Risk transparency: the key to a secure financial system

Published in Crikey

In Washington this week Prime Minister Kevin Rudd said, in reference to toxic assets polluting bank balance sheets, “This is the core of the global economic problem.” Actually the source of toxicity is the core problem and removing it central to restoring confidence and a lasting fix.

The global banking system collapsed because it is opaque. Giant financial institutions fell into their own massive risk holes. Risk holes grow out of sight as capital is attracted to assets with upside risk but with unseen hidden downside risk. Blind capital flows into risk holes like a bath-tub vortex drains the bath.

Risk transparency is the remedy. It avoids exposure to excessive unknown risk which means fewer and smaller surprises. Risk averse capital naturally flows away from transparent dangerous risk.

How is risk made transparent? Stress testing is the way to expose and measure risk holes. A stress test measures a bank’s balance sheet sensitivity to small and large changes in interest rates, exchange rates, property values and derivatives. It’s what VAR (Value at Risk), the global bank risk standard at the root of the crisis, does not do. Risk transparency simply means comprehensive price transparency — the most basic requirement of an efficient free market along with fair competition. Free market capitalism failed us because we never had it.

In February U.S. Treasury Secretary, Timothy Geithner, unveiled the Obama administration’s bank stress testing program. This was a defining moment in the management of the global crisis. It demonstrated Geithner’s grip on the problem. Apparently stress testing is also in the Brown-Rudd plan. However, as yet, no administration has mentioned the obvious and potent way to stress test the global banking system — that is, a permanent bank risk website delivering transparent, continuous, integrated, automated bank stress testing. It’s the kernel of a new global regulatory institution — the International Risk Monitor (IRM).

World leaders, the IMF, G20, FSF and Basel Committee all call for tighter regulations to fix the causes of the current crisis. The single most important regulation missing in the world’s financial system is enforcement of the IRM. A virtual place where all banks in the world must report daily their exposure to wide-ranging movements in all the economic variables to which they are exposed. Non-bank counterparties to OTC derivatives should also report. A market in regulated transparent credit derivatives can feed into the IRM to rate counterparty risk adding a further layer of security. The IRM is just an online integration of data every bank should already have on hand. The IRM needs bold leadership, standards, protocols, modest resources and time. There is no reason to delay the start. The first step in this direction will ignite confidence in the banking system. Any hesitation in real transparency justifies the fear in the banking system.

The IRM has many payoffs. It will forever immunise the global banking system against excessive risk in the most effective way possible. The market will self-regulate risk continuously. Sound banks are protected as malicious rumours wither with nothing in doubt to feed them. The market can see and deal with risk holes as they form before the storm.

Some attractive add-ons go with global integration of risk. Market risks can be netted across regions and industry sectors, automatically, daily for all to see. Derivative risk nets to zero, this has very important audit implications in a global risk system. Any global deviation from zero in the IRM is unreported dark risk in the system — an immediate alert to the risk cops.

At last week’s G20 meeting of finance ministers in Sussex Treasurer Wayne Swan was greeted with the news that the UK Foreign Office had placed Australia in its low priority list. It’s a measure of G20 confidence in Australia’s economic creativity. Mr Swan has the perfect Australian black swan remedy in the IRM, calming many storms as Mr Rudd flies to the April 2 G20 leaders summit.

Australia can set an example to the world now. We are told our banks are healthy. Let’s see it. Capture the ground of a new global financial institution.

Ralph McKay is the author of the book, “Risk Mechanics, Financial derivatives, finding and fixing risk holes”.

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

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

Value_At_Risk – Var Is a Dangerous Technique

Published in Euromoney’s Corporate Finance 1996 by Ralph McKay & T Erle Keefer

A means of representing risk as a single statistic is very appealing- and highly flawed, argue Ralph McKay and T Erle Keefer of consultancy Risk Technology. The value-at-risk method can conceal large risk holes, is insensitive to the possibility of catastrophic market events and ignores risk reshaping difficulties.

Value-at-risk and its new incarnations represent a form of risk appeasement. It ignores the real market risk problems. It is fashioned to impart a feeling of security to the people that it is supposed to give comfort to – central bankers, directors of banks and financial institutions, regulators and politicians. Objective scrutiny exposes this as unwarranted.

Given the notorious billion-dollar derivatives losses and absence of senior supervision, the clamour for a simplified risk measure such as value-at-risk is understandable. And the arrival of value-at-risk has served positively to focus attention on the need for risk measurement.

What is wrong with value-at-risk? Popular, broadly accepted definitions eschew too much essential information. They represent market risks as a single statistic. This single statistic is appealing and easy to explain. Unfortunately, it is even easier to use it to hide large risk holes. Managers consequently oblivious to the actual risk can increase systemic risk of derivatives bungles.

The manager presented with a value-at-risk number is like a fruit and vegetable trader who has a basket of fruit to sell but knows only the weight of the basket. He, along with the rest of the market-place, does not know from this single parameter whether the basket contains potatoes, mangoes, a mixed bag or bad apples. Thus he cannot determine what price to ask – he cannot assess the risk. To the fruit and veg trader, weight is not a market risk measure. Similarly, on a detailed analysis conventional values-at-risk are barely worthy of being treated as a measure of market risk.

Beware Tunguska Events

Even as a simple measure of risk, value-at-risk is highly exposed to criticism. Values-at-risk assume well-behaved markets but ignore the impact of real worry, the financial markets’ Tunguska events , such as the stock market crash of October 1987.

Derivative markets are very young. There is little data from which to predict the frequency of market crashes – that is the size and frequency of so-called outliers. But the limited data that exists is alarming and the only prudent approach is to assume that the big crashes have not happened yet. A prudent risk measurement must highlight exposure to the totally unexpected – because, in truth, it should be expected.
The value-at-risk concept of measuring risk in terms of a 99% probability of market movements is dangerous and misleading. For example, portfolios with deep out-of-the-money short option positions frequently show little sensitivity to the 99% movement. However, for even larger movements they may incur accelerating losses. Values-at-risk can be blind to this form of market jump risk.

Value-at-risk relies heavily on past statistics as a guide to the future. Another example of this is the actual or implied use of correlations between different markets and risk diversification. Negative correlations produce cancelling risks in the value-at—risk. Most of the time, diversification helps to minimize losses. However, when the security of diversification distracts attention from absolute protection risk management practice – as value-at-risk appears to be doing now its effect can be destructive in the medium to long term. This is because correlation and diversification assumptions can prove inadequate when the risk Tunguskas hit.

An absolute risk measure seeks to protect wealth in a defined manner regardless of the probability of adverse market movement. For example, the maximum wealth loss may be limited to an acceptable level. Compared with the value-at-risk 99% probability-type protection, outcomes between OK and destruction may be different when a Tunguska hits.

Risk reshaping

Quality risk management is only half the story; risk reshaping is its complement. For example, two portfolios may have identical value-at-risk numbers. However, the risk may be eliminated easily in one of the portfolios, whereas the other may be difficult to modify because of the bumps-to-the-risk-carpet problem. That is, attempts to control one aspect of the market risk may worsen other aspects.

The value-at-risk statistic ignores these risk-reshaping difficulties. Frequently, such complexities of risk reshaping may be the real risk problem, even though value-at-risk numbers may appear benign. Value-at-risk hides all information required to assess reshaping risk. Using the value-at-risk, it is impossible to determine which transactions are required to reshape market risks.

A single risk number ignores market asymmetry. A portfolio may be more exposed to loss than profit, but this cannot be known from the value-at-risk number. Its limitations extend to overall trading philosophy.

Value-at-risk tends to give validity to the popular notion that financial institutions make money by incurring market risks. The more risk, the higher the potential returns. This is a myth. The target value—at-risk number should be zero. All risks should be fully hedged — particularly in zero-sum markets. The objective should be to eliminate market risk, leaving only counterparty and operational risks to worry about.

This is the case when a bank sees itself as a manufacturer of financial instruments. Such a manufacturer may not be able to achieve the ideal zero-risk position at all times, but how many senior bankers hold the misguided belief that a zero value-at-risk means zero profit?

The underlying reality is that market risk management is a complex problem. It is dangerous to oversimplify the issues. An effective set of risk numbers should indicate the present value change in the portfolio in response to all economic parameters affecting the portfolio, whether correlated on not, and indicate exposure to both small and and very large moves. If the portfolio is properly hedged, the exposure to a very large market jump may be the same as the exposure to smaller moves — zero.■

The ‘Tunguska event was a large mysterious aerial explosion in Siberia at 7.40am on June 30 1908. It devastated 500,000 acres. It is thought to have been caused by a comet. June 30 remains the financial day of reckoning for many companies.

Published version – Euromoney’s Corporate Finance – 1996