War on VAR

This post from Urbanomics set me thinking about the most popular tool in risk management- Value at Risk (VAR). I had pointed to this primer on Value at Risk and had forgotten about it.

Urbanomics points to a series of articles on the subject. The discussion starts with this article from Joe Nocera on VAR. (BTW, Nocera created quite a storm with his articlepraising Dr Reddy). The article was criticised by Yves Smith of Naked  Capitalism Blog calling it misleading. James Kwak of Baseline Scenario neatly sums upNocera and Smith views:

While Smith focuses on the problem of using the wrong mathematical tools, and Nocera mentions the problem of not using enough historical data.

(In other words Smith criticises that most VAR models still assume normal distribution curves. We all know financial markets cannot be represented by normal distribution bell shaped curves anymore.)

Kwak adds another weakness – the scenario changes over a period of time. Stock/Asset prices are influenced by numerous investors and one is always unsure how much weight should you give to future. So, we may get VAR value using the past values but can never be sure how much the future will change. This puts entire VAR calculation into a fix.

 Further Kwak points:

There was one part of Nocera’s article that I liked a lot:

At the height of the bubble, there was so much money to be made that any firm that pulled back because it was nervous about risk would forsake huge short-term gains and lose out to less cautious rivals. The fact that VaR didn’t measure the possibility of an extreme event was a blessing to the executives. It made black swans [unlikely events] all the easier to ignore. All the incentives — profits, compensation, glory, even job security — went in the direction of taking on more and more risk, even if you half suspected it would end badly. After all, it would end badly for everyone else too. As the former Citigroup chief executive Charles Prince famously put it, “As long as the music is playing, you’ve got to get up and dance.” Or, as John Maynard Keynes once wrote, a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”

This, I think, is an accurate picture of what was going on. If you were a senior executive at an investment bank, even if you knew you were in a bubble that was going to collapse, it was still in your interests to play along, for at least two reasons: the enormity of the short-term compensation to be made outweighed the relatively paltry financial risk of being fired in a bust (given severance packages, and the fact that in a downturn all CEO compensation would plummet); and bucking the trend incurs resume risk in a way that playing along doesn’t.

If you were an individual trader, the incentives might have been the opposite: shorting the market was an opportunity to make a name for yourself and open your own hedge fund, while buying more mortgage-backed securities would just keep you in the same bonus tier as everyone else. But it’s the CEOs who called the shots, and their personal risk aversion was what mattered. Or, in the brilliant words of John Dizard (cited in the naked capitalism article):

A once-in-10-years-comet-wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a “résumé put”, not a term you will find in offering memoranda, and nine years of bonuses.

After Greenspan/Bernnake put, we had emerging market call option and now resume put. All this makes me recall an excellent paper from Dean Foster and Peyton Youngwho show how difficult it is to seperate a con fund manager from a real one. One should also read Ragu Rajan’s analysis.

Now, coming back to risk management. I have always wondered why so many people who call themselves as risk managers/engineers/specialists fail to see these events so regularly? This department also attracts the highly talented people for the challenges and incentives it offers. They all come from top B-Schools/ Finance Schools and know the limitations of VAR . Infact you talk to any one from risk management of a finance firm and they would tell you they use many more tools apart from VAR.  The job is one of high prestige and they should be more than happy to call the shots, as signalling risks leads to more prestige for them.

I can at present think of two reasons. One, in good times you don’t want a risk manager saying not to lend/borrow etc. Infact, if you hear the risk manager there is a huge chance, you do not grow as much. So, as a result risk management takes a backseat and you let the sales guy call the shots. The risk managers also don’t mind as common they get higher incentives too.

Second reason is herding/peer grouping. Well, there could be some finance firms that let risk management call the shots even in good times. However, when they see others growing so fat, they simply cannot stand back and do nothing. Infact, numerous articles now a days show how the various financial firms became aggressive on sub-prime assets after seeing other firm do well on the same. This is a case we saw in India as well with banks going crazy on their loan portfolio. One got atleast 10 calls from different banks offering home loan, auto loan etc. You could see this being aped across banks. Now a days getting a call in a week is a rarity (infact, those who have taken loans might be getting a few to pay up!).

So, where does all this take us. I think it all boils down to how greedy one gets. All these models like VAR etc are just tools and let us face it no tool is perfect. The tools depend on numerous assumptions and are fairly complicated for anyone to understand. So, one assumption is violated and the whole thing crashes (for instance in subprime CDOs an assumption was we can never have a nationwide housing market crash). So, we can have more fancier models and tools (which am sure will come after the crisis) but we can never be sure of the risks involved. 

However, this does not imply risk managers are not at fault. They oversell their models and tools showcasing them to be gods of financial markets who can predict it all. They should be more sober and realise that predicting risks in financial markets is much more complex than their models.

I can’t think of a better example than LTCM. It had the best brains and all who is who in their team. They must surely be aware of the risks but the greed was too much to overcome. Reading LTCM books by Roger Lowenstein and Nick Dunbar one gets awed by two things- one the team (of course) and two the greed.

The best bet is for the financial market as a whole is to be less greedy which is obviously a  very difficult thing to do. After all, we all rever Gordon Gekko and remember his golden words -‘Greed is Good’.

About these ads

2 Responses to “War on VAR”

  1. azoptimist Says:

    “What goes around comes around.”
    Greedies beware. You may be duped someday, too.

  2. War on VAR Says:

    […] This post from Urbanomics set me thinking about the most popular tool in risk management- Value at Risk (VAR). I had pointed to this primer on Value at Risk and had forgotten about it. Urbanomics points to a series of articles on the subject. The discussion starts with this article from Joe Nocera on VAR. (BTW, Nocera created quite a storm with his articlepraising Dr Reddy). The article was criticised by Yves Smith of Naked  Capitalism Blog calling it misleading. James Kwak of Baseline Scenario [Read the full article here] […]

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s


Follow

Get every new post delivered to your Inbox.

Join 1,255 other followers

%d bloggers like this: