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Capital Markets

Don't rely on VaR

Belief that a single number can capture the degree of risk being taken within a bank or an investment is mistaken, especially when that number is value at risk. Markus Leippold explains why the measure is flawed, points to the dangers of its widespread acceptance by regulators and investors, and suggests an alternative.

REGULATORS, POLICY MAKERS, and investors increasingly put pressure on banks, securities firms and hedge funds to include risk information in their financial reports. These groups want to understand the amount of risk being taken to produce returns so as to make better-informed judgments on the performance of financial institutions and investments.

To assign a number to returns is easy. It is the percentage number indicating by how much the money value of an investment has increased from the previous period. But what about risk? In the end, what generates return is the risk we take. How can we measure it in a way that facilitates comparison between financial institutions and investments? It seems that the financial industry and regulators have found a consensus: the buzz phrase is value at risk (VaR).

However, VaR is the wrong concept for measuring risk. Over-reliance on it is itself a growing risk for the global financial system.

Most market regulation frameworks are based on the 1996 amendment of the Basle Committee's 1988 Accord. The amendment recommends the use of VaR as the relevant figure for determining regulatory capital reserves for banks' market risk exposure.

Moreover, in Basle II the Bank for International Settlements is about to extend this VaR-based reporting practice to credit and operational risk.

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