May 25, 2007
A reason to defend VaR
In continuing on with the debate on VaR, I agree with some of the comments that were made to the previous blog article and I accept I was hard with my critique. Sure VaR may not be the panacea of risk measurement that it is proclaimed to be but it has some good attributes, starting with the way in which it translates relatively well from market to other disciplines of risk such as credit and this is kind of neat. What is the saving grace is that it is parametrically based and focuses on losses. Up until VaR became a relative standard some banks used what I would classify as exciting alchemy to define the chemistry of causality for their potential loss with the occasional Fibonacci related approaches really taking us to the exotic edge of measurement. Many organisations didn't adopt anything cognisant at all and some still operate this way.
What is important to the industry as a whole is that it finds a reasonable measure of exposure that can be commonly accepted, stochastically sound (whatever that is) and is not refined for one investment strategy over another otherwise transparency and exposure rating is lost.
VaR meets the majority of the criteria to take the world of capital measurement global however many analysts claim expected short fall is a better approach for tail work. Expected Short Fall is the conditional expectation of loss given that the loss is beyond the VaR level and it again is still working in a coherent domain.
The real catch that so many oversee is not that VaR underestimates or overestimates exposure, it is the requirement of including correlation and aggregation that is complex and without these two the VaR calculation is likely to be lower in weight. When a risk analyst drops aggregation from the calculation only to do it post simulation the VaR calculation could lead an organisation to position where it might measure exposure in a manner that lacks subadditivity. Subadditivity implies that aggregating individual risks does not increase the overall risk and that is mathematically expressed in the following way. For all X and all Y, p(X+Y) <= p(X) + p(Y)
What we have here is a deficiency where a decentralised risk framework may be flawed because VaR is calculated on individual portfolios which cannot be aggregated to produce an upper bound of loss and Rudiger Frey and Alexander McNeil published a paper on this quite a few years back when VaR was all the rage in Europe. Another issue with VaR is that investment portfolios have become exponentially complex and contain exposure of many natures including a blend of credit, market and operational risk. This can be seen in the new hybrid derivatives or mitigation alpha investment strategies that are now popular and which for what its worth are fantastic investment approaches with a real purpose but from a risk perspective; is the overall exposure being measured correctly? Is the inference between the arbitrage space of the pure risk disciplines being reported? Perhaps the real concern is that advanced investment strategies are being used by an ever growing investment community and I fair I am not the only one with this fear as many regulators are showing apprehension over the increase in popularity of hedge funds globally.
To close off on this, I see VaR as a stepping stone to a more sophisticated technique of exposure measurement and I agree with you entirely that there may be a better way but we are on a path and in reality the industry as whole has a long way to walk yet. Some banks are stuck on Basel I, some are adopting the basic approaches to capital estimation which is a tragic representation of failure, barely risk based at all and puts expression of loss and capital reserves as nothing more than a proxy of revenue. So now the industry has accepted VaR, we might all just be in a risk renaissance here where VaR is the Euclidean equivalent of risk reasoning just as Greek mathematics opened the space for geometry 320BC and while banks are moving onto risk based capital regimes, VaR might be a likely vehicle to embed a risk based approach in the financial sector and while its doing that, I will defend it.
Posted by CausalEvents at 04:14 PM
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May 18, 2007
Defending an argument against VaR
A recent article published on RiskCentre news from the author IRA staff on the subject 'Will Basel II finally discredit VaR' left me shocked and raised an eyebrow, actually both of them shot up. This journal critiques some of the assertions that were made against a backdrop of logical thought but before we begin I have to state one theme left me slightly disappointed. When someone slings hard unjustified criticism against a maxim but does not offer an alternative we are left with little option but to diffuse some of the affirmations into the pool of white-noise. All that said, being a dedicated risk professional I feel it my duty to at least point out another light on the hill in the relative risk world of darkness.
This is where it started:
[AUTHOR IRA STAFF] <<< Where we asserted that the use of risk pricing tools such as Value at Risk or 'VAR' models and other types of statistical routines arguably amplified the effect of excess liquidity, boosting the throughput of the Wall Street vastly expanding the pool of risk for end-users.>>>>
Firstly before we refute this, what is VaR?
Value at Risk or VaR is a measure of potential loss from an unlikely adverse event in a normal everyday market environment. It is an expensive measure of risk because it focuses on the worst case event (the tail of the loss curve) and thus in our simple definition alone we would realize that the use of VaR is likely to reduce liquidity or funds available for investment because a larger holding of capital for potential loss would be required by the institution when the institution focuses at the end of the curve rather than the body or mean.
After some debate the article then accepted this point and followed on with ...
[AUTHOR IRA STAFF] <<< To review, VAR models summarize the expected maximum loss (or worst loss) over a target horizon within a given confidence interval. To us, this is an elegant way of saying "I don't know. >>>
Lets be totally real here, a spiritually centred person is aware of this and so is the wise investor. We simply don't know the future and this conundrum has been plaguing man since he realised that some inkling into what might happen can be derived by speculating on outcomes from past events with the same properties. Surely this insight is far better than no perception at all however the argument is actually more profound than this. Assume for example we did know what is going to happen without question of doubt and there was no such thing as chance, then one could argue does opportunity exist at all? To engage in opportunity is to invest a resource into an entity which has potential to move past its current position to a higher one and the steeper the potential the higher the return. Now remove that tensile gap and the price will flatten for everything that is instantly available without limit has little value be it important or not. VaR is the worst case scenario of this tensile gap so it makes a conservative estimate on what could go wrong and that surely has to be the most sane approach to any investment strategy. VaR departs us from our own myopic delusional sentiment and brings all estimates to a single view of exposure.
Looking at the next argument from the article
[AUTHOR IRA STAFF] <<< The trouble with VAR models is that the methodology says nothing about specific risks regarding specific transactions, yet provides risk practitioners with the false impression that the particular risk has been measured >>>
This is not true, the technique for deriving VaR is through the use of variance/covariance, Monte Carlo or historical simulation and it involves using historical data which in our above example is the set of circumstances on a current investment position and the potential for these prices to move away from what we believe or want. These inputs are often combined in different ways depending on the method so that an estimate of a particular percentile of the loss distribution, typically the 99th percentile of loss is created. Now after these calculations only the foolish analyst would throw away his data, equations, documented techniques and workings. What is false about the risk measure is that the 99th percentile of loss is quite improbable and sanely conservative but still VaR should not be expressed alone, it should be justified like any estimate and back tested for accuracy.
Then like many authors with an agenda they made a set of convoluted linguistic twists so that the reader would land at a point where the contraction and change in article direction would be lost. The sad result was the following statement:
[AUTHOR IRA STAFF] <<< Simply stated, if the overall risk calculated in the VAR model appears to be low, then additional risk may be taken >>>
Hang on its the worst case loss, its the 99.9th percentile position, how can that be low however the author did introduce an interesting concept. To be concise the insertion of the word 'additional' is impacting in a risk measure. 'Additional' lends us to believe that each marginal choice in a network of risk based decisions actually has the propensity to conceal the real potential loss from the starting position of an investment. That is, it is a human tendency of error to forget the tally of wins and losses when a goal seems ever so close especially when we just read our risk profile over a short stint in time.
The article did stipulate a real fact in respect to Pillar III, thank the world of regulation for that.
[AUTHOR IRA STAFF] <<< Pillar III of Basel II, the requirement for market discipline, where banks will be compelled to publicly disclose and benchmark the efficacy of VAR models against their actual results, including public 'mark-to-actuals' results for VAR, Defaults, Loss Given Default and Exposure at Default, etc. Will Pillar III ultimately be the undoing of VAR? >>>
What worries me however is that the US regulators are yet to fully adopt an approach for Basel II, landing between the first version of the accord and some advanced standard approach. Really the advantages of Pillar II and III are probably a long way off for US bankers even though Pillar II and III could seriously assist in publishing the true volatility US institutions are exposing themselves to.
Now to finish up the author stated the following:
[AUTHOR IRA STAFF] <<< Just as global regulators are enshrining VAR as the centerpiece of the Basel II regime, markets may demonstrate that this method of measuring risk is entirely useless >>>
VaR is not new to the 'global' banking community and just because regulation is adopting what most investment institutions are using will not demonstrate that this measure of is risk is entirely useless. My dear people, financial institutions have been using VaR to explain the Greek measures of market risk for sometime. VaR simplifies the varied measures of this exposure type so that expressions of threat can occur in a transparent manner. In my opinion, this is overstated and a touch sad. Its authoritarian sounding no doubt about that and it may just fool some, confuse the masses perhaps, but without an alternative and with assumptions missing I have to rebuke that VaR is entirely useless.
Posted by CausalEvents at 11:28 PM
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May 11, 2007
MAS is CRAFTing a Risk Assessment
The benefits of the CRAFT approach to risk assessment in Singapore, drawing on the unique approach that the Monetary Authority of Singapore has engaged to measure risk across the Island.
Late last year I finished up on a subject that generated some interesting responses for principle based regulation and since that time I haven't blogged which some readers have made comment to. So to pick up where I left off we are going to look at another not dissimilar approach to regulation in South East Asia but before we do, please accept my apology for not publishing and I can guarantee since last year I have looked at a little bit more than principle based regulation, well we hope so. Specifically Causal Capital is in the process of building a new operational risk tool for banks and that has been consuming a lot of my time but more on that in another space.
So back to principle based regulation or perhaps risk based regulation and last month the Monetary Authority of Singapore published its framework for Impact and Risk Assessment of Financial Institutions and its approach is relatively fresh and novel but before we delve into the semantics of this CRAFT one needs a little bit of insight into Singapore.
Singapore is an island city state nested between Malaysia and Indonesia and it runs like clockwork with the Economist ranking Singapore as the 11th most advanced in quality of life globally. Geographically its small being about 50km's or so long and 30km's or so across yet it packs in one of the most dense financial sectors in the world. Singapore is successful because it manages economic and political volatility swiftly so that systemic threats are treated. The outcome of this management machination results in a stable landscape and that attracts foreign investment, business and working capital; the driving force for the success of the country.
The Monetary Authority of Singapore's recent publication embellishes this very instrument to wellbeing and should be viewed in this light.
Like the FSA (Financial Services Authority) in the United Kingdom, the MAS approach is principles based yet it is structured in a way that makes best use of resources at hand to ensure that the principles are targeted where they are most needed and it does this with an industry wide impact assessment known as CRAFT or to escape the acronym; Common Risk Assessment and Techniques.
As MAS puts it 'the supervisory work addresses themes that affect the industry as a whole and issues that cut across different financial service sectors' and it works by articulating an impact risk model across the entire financial sector by first evaluating the rate and impact of a specific risk for one institution, then bench marking that threat in a back drop against the financial sector as a whole.
The concise risk steps involve the investigation of risks in the context of each institution and a direct connection to the outcome or impact. By reviewing the importance of what is at risk and the impact, risks are collected for each institution individually and the overall exposure assessed. MAS combines the relative systemic importance of the threat and the risk outcome profile to dimension a close proximity to the impact and then rates this into one of four 'supervisory buckets' and for each institution in turn. Level 1 buckets have the greatest potential of affecting the goals of MAS and level 4 risks are concerns that need monitoring.
From a regulatory perspective CRAFT has some distinct advantages, primarily it is risk focused so that each regulatory decision is based against a threat rather than some bureaucratic policy that just remains for the sake of its existence. In addition to this, an action is not practiced in discrete and rigid steps but operates to resolve the present problem in the best manner and this makes the approach in Singapore very Principles Based. The neat part to it all is that when a risk is managed, transferred or mitigated a policy is relaxed to free up resources to the next most pertinent threat. From a commercial perspective financial institutions are not 'interfered' with unnecessarily which translates to a lower cost of compliance. Alternatively countries that have heavy regulation dissimulated by several regulatory bodies have a tendency to over regulate resulting in duplication and higher costs. Now while I can see specific analysts assailing such an avouchment, I can also find more chief executive officers whining in the peanut gallery of the stadium of regulation with some semblance of agreement.
The most effective outcome of CRAFT however is that it is ever evolving so as threats appear a course of action is mapped. This technique lends itself quickly to the analytics of trends of potential vulnerabilities so that they can be written into policy for a quick resolution. Something else novel about the MAS approach is that this sorting of threats is actually applied to all disciplines of risk equally. It takes in market, credit, liquidity and operational risk so the tendency to correlate interdependencies to highlight a resident pathogen between risks ensures that the focus is on resolution rather than finger pointing. This holistic approach is also ideal for defining systemic failure and failure from the network of dependencies between risk elements and all of this seems relatively obvious but so many other regulators treat risks in silos.
The regulatory document can be downloaded from the MAS website and it is a concise read being only 22 or so pages.
Posted by CausalEvents at 05:14 PM
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