Friday, September 11, 2009

Leverage ratios are the new VaR?


What happens when you get Rick Bookstaber and Nassim Nicholas Taleb in the same room, to talk about one of the most controversial risk measures of the financial crisis?

They (almost) agree.

The two were speaking in front of the US House of Representatives Committee on Science & Technology, which met yesterday to discuss the role of financial modelling in the recent financial meltdown. As Reuters blogger Felix Salmon points out, the two risk-writers have had their differences in the past, notably about the usefulness of Taleb’s Black Swans, or fat-tailed events that no one foresees.

While the two come up with similar ideas about what could replace VaR as the dominant measure of banks’ risk for the committee, there were nevertheless differences in their opinions.

From Rick Bookstaber’s statement:

There are two approaches for moving away from over-reliance on VaR.

The first approach is to employ coarser measures of risk, measures that have fewer assumptions and that are less dependent on the future looking like the past
. The use of the Leverage Ratio mandated by U.S. regulators and championed by the FDIC is an example of such a measure. The leverage ratio does not overlay assumptions about the correlation or the volatility of the assets, and does not assume any mitigating effect from diversification, although it has its own limitations as a basis for capital adequacy.*

The second approach is to recognize that while VaR provides a guide to risk in some situations, it must be enhanced with other measures that are better at illuminating the areas it does not reach. For example, Pillar II of Basel II has moved to include stress cases for crises and defaults into its risk capital process. So in addition to measuring risk using a standard VaR approach, firms must develop scenarios for crises and test their capital adequacy under those scenarios. Critical to the success of this approach is the ability to ferret out potential crises and describe them adequately for risk purposes.

And Taleb’s:

Regulators should understand that financial markets are a complex system and work on increasing the robustness in it, by preventing “too big to fail” situations, favoring diversity in risk taking, allowing entities to absorb large shocks, and reducing the effect of model error (see “Ten Points for a Black Swan Robust Society”, in Appendix II). This implies reliance on “hard”, non-probabilistic measures rather than more error-prone ones. For instance “leverage” is a robust measures (like the temperature, it does not change with your model), while VaR is not.

So are leverage ratios the new VaR?

While many of VaR’s failings are due to the fact that the measure largely relies on banks’ own inputs, leverage ratios, we imagine, are prone to the same sort of manipulation. In fact, Bookstaber points out in his statement that off-balance sheet positions, and even CDOs, weren’t included in some banks’ VaR calculations.

Surely off-balance sheet positions wouldn’t be included in leverage ratios either. In fact, this is something Bookstaber himself remarks upon in his footnote:

*The Leverage Ratio is inconsistent with Basel II because it is not sensitive to the riskiness of balance sheet assets and it does not capture off-balance sheet risks. By not taking the relative risk of assets into account, it could lead to incentives for banks to hold riskier assets, while on a relative basis penalizing those banks that elect to hold a low-risk balance sheet. In terms of risk to a financial institution, the time horizon of leverage is also important, which the Leverage Ratio also misses. The problems with Bear Stearns and Lehman was not only one of leverage per se, but of funding a sizable portion of leverage in the short-term repo market. They thus were vulnerable to funding drying up in the face of a crisis.

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