Nov 5, 2013

Reconsidering Risk-Models: VaR vs. Expected Shortfall

According to a recent Bloomberg story by Jim Brunsden titled “Banks Face Risk-Model Clampdown in Basel Trading-Book Review” the Basel Committee on Banking Supervision is expected to publish draft proposals in the coming weeks on capital rules for assets that banks intend to trade. While it’s clear the differences in the risk-models used by banks is creating major differences in valuations, the aim of the Basel proposals would be to address variations in different banks’ risk measurement and toughen rules on how much information banks have to disclose about their models.
In this video blog, Udi Sela, VP of the Numerix Client Solutions Group and Jim Jockle, Numerix CMO discuss the latest industry debate and regulatory implications around the adoption of risk models and standardized approaches – including challenges associated with the shift to expected shortfall of tail risk versus VaR.
Watch the Video: Reconsidering Risk-Models: VaR versus Expected Shortfall

Weigh in and continue the conversation on Twitter @nxanalyticsLinkedIn, or in the comments section.

Video Transcript: Reconsidering Risk-Models: VaR versus Expected Shortfall

Jim Jockle (Host): Hi welcome to Numerix Video Blog, I’m your host Jim Jockle. With me today Udi Sela, Vice President of the Client Solutions Group. Udi, how are you?

Udi Sela (Guest): I’m good Jim. Good to be back.  

Jockle: Always good to have you. Sir, we’re talking about Basel III. New rules are poised to come out as soon as this month for comment period which really is going to create a clamp down on some of the elements of the trading book. More importantly is the move from VaR to expected shortfall as of measure. Could you give us a little bit of an update and background on what is expected shortfall?     

Sela: Yes. So you know, historically it started with VaR at JP Morgan at the time when basically the CEO of the bank wanted to know what is the expected (typically daily) loss at a probability level of 99%. And so he was just looking for a number. So his Middle office came back with VaR. Which since then became a more or less an industry standard. Now we saw during the subprime crisis –fact is that (VAR) was not good enough

Because it’s very good to know that the 99%, this is my loss. But what happens when you hit the 1%? Well what some people call the tail risk, right? And this is exactly what expected shortfall is there to measure - Losses at the tail. And of course you know that there are hedging strategies that try to capture these vast market movements and how to make money when the tail is hit. So, this is something that now is being very much looked. 

Jockle: So one of the questions is – historically because of the VaR models, you had wide variation in terms of reporting while not looking at the tail risk in the book. But, what are the implications? I mean one of the proposals that came out is perhaps looking at the standardized model, versus the advanced model for implementation from posting of collateral almost as a floor charge. How is this going to change or standardize the way the banks report and what are the implications for trading? 

Sela: Right so let’s try to put some order in this. So the first thing we need to know is this is really about setting capital aside for potential losses. This is where it all starts from. Now, if everything was traded at exchanges and prices were transparent then everyone would report the same numbers. Today the fact that people are using either the simplistic model, or more advanced models, means that we have variations in the valuation of books and risk.

And as a result, with the capital set aside. So potentially you could have a case today with two banks with exactly the same trading book, trade to trade. But will report different numbers totally and would set different levels of capital aside (using different models to value their books). And this is something that the regulators don’t accept, or try to clamp down if you like. And what is being proposed really is to use a more standardized approach. So even if you set aside capital and you choose to use a more advanced model, you’ll have probably less freedom in selecting the model. And the way to incite banks to do that would be via capital charges. 

Jockle: So one of the things that I wanted to get a reaction to your quote from this Bloomberg article by Jim Brunsden on October 21st and the quote was from Karen Shaw Petrou, Managing Partner of a Washington based research firm, Federal Financial Analytics. And in the email, the response was: “Alternatives to VaR, might better balance risk versus industry need, but can only be determined after review of the proposal. Even if the move away from VaR is less subject to gaming by banks, it’ll create tremendous arbitrage opportunities that can move trading out of the banking system. This may be Basel’s desired result, but if so, it should say so.”

Talk about a little bit of, it’s a fascinating quote and clearly the Basel (audible out) argue not necessarily move trading out of the banking system, but talk about the arbitrage opportunities that could arise from this move. 

Sela: So I think that we’ve already discussed this in previous video blogs that we’ve conducted together. That the regulatory arbitrage. This is what it is about. So we see that propriety trading is moving out from the sell side to the buy side. We can see that in terms of investment. We can see in terms of propriety traders either moving to existing hedge funds or forming new hedge funds. And that’s exactly the thing. If the buy-side is less regulated and is less subject to capital charges or capital adequacy, then they have a lot more opportunities to take on risk and the cost of trading for them is lower, or if you like the flip side, you can look at it as leverage opportunities are higher. So this is what this is really about in my opinion.

Jockle: Well Udi I think that we’re going to have a conversation again as we do see the rules coming out in the next few weeks and we’ll have some more specifics exactly around what Basel Committee is thinking and putting into the market because I think this is going to be a very interesting comment period to watch. As well as think about some of the challenges that institutions are going to have adopting expected shortfall of tail risk, into not just in their reporting, but into their trading strategies.

So Udi, I do hope that you’ll join us again as we get some more clarity out of the committee and of course feel free to stay in touch with Numerix. Follow us along on twitter @nxanalytics.

Stay in touch with us and all of the things we’re bringing to market in terms of webinars and videos on our LinkedIn page as well. And of course we want to hear from you and talk about the topics that you want to talk about. Udi thank you for your time today. 

Sela: Thank you it was a pleasure. 

Jockle: And we’ll see you next time. Thank you. 

Sela: Thank you goodbye. 

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