On Thursday, the US House of Representatives Committee on Science & Technology will turn its attention to financial modeling.
Specifically, the committee will be scrutinising the role of the much-maligned Value-at-Risk model, which was meant to measure the maximum loss on a banking portfolio at a given probability and time horizon, in the current financial crisis.
More importantly, they’ll be looking at whether VaR can be an appropriate guide for setting capital requirements.
Basel I and Basel II banking rules are already based on the model, and recent post-financial crisis tweaks also use the measure — albeit a ‘stressed’ version. In doing so, the committee will be calling a number of financial experts as witnesses — notably Nassim Nicholas Taleb, of Black Swan fame, author and blogger Rick Bookstaber, and Christopher Whalen of Institutional Risk Analytics, which provides stress ratings for banks and other risk management services.
Chris has been kind of enough to forward an advance copy of his statement — which provides a taster for tomorrow’s hearing:
The term “model” as it applies to finance can be a simulation of reality in terms of predicting future financial outcomes. The author Nassim Taleb, who is appearing at this hearing, says the term “VaR” or value at risk describes a statistical estimate of “the expected maximum loss (or worst loss) over a target horizon within a given confidence interval.”
VaR models and similar statistical methods pretend to estimate the largest possible loss that an investor might experience over a given period of time to a given degree of certainty. The use of VaR type models, including the version imbedded in the Basel II agreement, involves a number of assumptions about risk and outcomes that are speculative. More important, the widespread use of these statistical models for risk management suggest that financial institutions are subject to occasional “Black Swans” in the form of risk events that cannot be anticipated.
We take a different view. We don’t actually believe there is such a thing a a “Black Swan.” Our observations tell us that a more likely explanation is that leaders in finance and politics simply made the mistake of, again, believing in what were in fact flawed models and blinded themselves to what should have been plainly calculable innovation risks destined to be unsustainable. Or worse, our leaders in Washington and on Wall Street decided to be short sighted and not care about the inevitable debacle.
You can expect some passionate debate, or at least, about as impassioned as you can get when it comes to matters of quantitative finance, when the meeting starts at 10:00 am local time on Thursday. Those in the Washington DC area can even attend in person — Room 2318 Rayburn House Office Building.
The full schedule and charter of the hearing is available here.
Related links:
On baseline VaR – FT Alphaville
Stressed-out VaR – FT Alphaville
On Goldman’s fat tail risk – FT Alphaville
VaRy complex — FT Alphaville