Why value at risk holds its own
The increasing complexity of financial instruments, markets and institutions is a worry for regulators and investors. Simple, intuitive ways are needed to make risk transparent. The value-at-risk measure, although sometimes criticized on theoretical grounds (see Markus Leippold in Euromoney November 2004), has established itself as the benchmark. Christopher Lotz and Gerhard Stahl explain how regulators approach the subject of market risk management and use VaR as one among many tools.
By Christopher Lotz
Don't rely on VaR - Markus Leippold, Euromoney November 2004
Regulatory market risk
MANY FINANCIAL DISASTERS could have been averted had banks' risk management processes been working properly. For example, the losses in foreign exchange trading at National Australia Bank, one of the most prominent financial scandals of recent years, were preceded by a breakdown of management confidence in value-at-risk numbers resulting in a complete disregard of limit breaches.1 It is a clear case of a collapse of the risk management process, rather than the inadequacy of VaR as a risk measure. What is the risk management process about? It is about communication and the reduction of complexity into simple, understandable terms on which decisions can be based. Many ways to describe and compare risk exist, each with its advantages and disadvantages. VaR is only one of many possibilities. It was selected by the Basle Committee as the basis for calculating regulatory capital for market risk because it has desirable properties that we will describe below. But whether risk is communicated in terms of VaR, stress test results or sensitivities is of secondary importance compared with the functioning of the risk management process as a whole.