Lord Turner’s speech at the Economist’s Inaugural City Lecture yesterday is really worth a read: broad without being generalised, nuanced without being technocratic. It more or less covers all the bases and is an excellent brief on the current financial crisis.
We were particularly taken with the comments on Basel II. And of those, the criticism of VaR stood out (emphasis ours):
…in respect to the trading books of banks, we need to remove pro cyclicality and to increase capital requirements not just marginally but by several times. The present system of capital regulation of trading books is from a prudential point of view seriously deficient. Its reliance on value at risk [VAR] measures derived (usually) from the observation of the last year’s movements in market prices is clearly pro cyclical: if volatility goes down in a year, the measure tells banks that risk looking forward have reduced, and thus fails to allow for the fact that historically low volatility may actually be an indication of irrationally low risk aversion and therefore increased systemic risk. It [VaR] fails to allow effectively for the low probability tail events which are crucial to extreme idiosyncratic and even more so to overall systemic risk. And overall, the level of capital required against trading books has been simply too low relative to the risks being taken, given what we now understand about the systemic dangers of relying on liquidity through marketability, and about the susceptibility of securitised credit markets to irrational exuberance, suddenly liquidity disappearance and rapid price collapse. Major banks with a large percentage of their balance sheets devoted to trading activity, have been required to hold only very thin slices of capital against it [Exhibit 16]. That will change radically given the proposals already issued by the Basel Committee, and these changes in themselves are likely to result in a significant contraction in the scale of future trading books.
You can view the slides that accompany the lecture here. The one Lord Turner mentions above – 16 – is worth singling out:
While the speech was excellent, and Lord Turner’s criticisms of VaR in the Basel II regime might be spot on, the trouble is, they don’t seem to wholly gel with some of the latest policy actions taken by the FSA (though we’re still open to correction on this point). Which makes us wonder.
On Monday, the FSA announced changes to its interpretation of the Basel II bank risk weighting requirements to allow them to move away from something called point-in-time modelling and more towards something called through-the-cycle modelling using something else called a variable scalar method. Bear with us…
The biggest problem with the variable scalar approach and through-the-cycle modelling is that it contains the same fundamental philosophical errors as VaR itself: it invites dependency on inadequate series of historical data to make assumptions about the future and the modelling demands it places on portfolios insufficiently captures the dangers of correlation crises. Or to render that into English: it ignores extreme risks – fat tails. Indeed, the FSA’s proposals are very much more of the same kind of financial modelling that brought the banks to their knees in the first place.
Perhaps it is that, in light of Turner’s speech, the FSA’s changed stance on variable scalar modelling should be viewed as temporary; a pragmatic short-term response. Afterall, as Lord Turner notes, the ball is really now in the Basel II committee’s court anyway.