Searching for New Paradigms at BIS: Market Turmoil Has Thrown VaR, and Basel II, a Curve

[ILLUSTRATION OMITTED] To central bankers, the implementation of the Basel II Capital Accord was planned as a stimulant to improve banks management practices, as well as to formulate appropriate, risk-sensitive capital levels for the global banking system. [ILLUSTRATION OMITTED] Now, after building up very high expectations and investing enormous intellectual capital in the reformulation of Basel II, many bankers and regulators, not to mention bank investors, have fallen disappointed at the unexpected deficiencies in banking capital, especially for complex global financial institutions, that have been exposed by the recent market turmoil. Even the improved management systems of these large banks--as stimulated by Basel II--have become orphaned by their erstwhile supporters. Consider that, for the past dozen years or so, the most popular paradigm has been VaR, or, value at Central bankers seem to have concluded that banks that relied on VaR tended to operate in ways which exaggerated the banking systems' natural procyclicality. That is, banks using VaR made too many loans into the credit boom economy, resulting in an overstimulation of the business cycle. VaR failed to prevent participants from building excess leverage, especially when market volatility was deceptively low. As a result, the VaR techniques be complemented by stress testing and by basic judgment and indicators, the deputy general manager of the Bank for International Settlements, Herve Hannoun, told a group of central bankers meeting in Ottawa on May 8. Among the simple indicators to be considered, Hannoun proposed maximum loan-to-value ratios for mortgage loans, capital charges on structured investment vehicles, leverage ratios, and dynamic provisioning. Each of these has a precedent in one or more national regulatory structures, he pointed out. Three weeks later, his boss at BIS, general manager Malcolm Knight, told a meeting of international securities regulators in Paris on May 29 that risk managers must rely on a wider range of tools to capture the multi-dimensionality of because tail exposures--including the of illiquidity--are not well measured by tools such as value at risk. Despite the relative rarity of losses out on the tails of a distribution, in some cases the bell-curve-shaped distribution is so flat that the actual value of losses can bankrupt banks and threaten financial markets. The bottom line on VaR is that it is so reliant on volatility as a measure of risk, that VaR adherents missed the entire accumulation of risky positions since there was very low volatility. Knight recommended several corrective actions in order to reduce the risks in today's market-dependent financial system. To begin, he emphasized the need for less complexity and more transparency in the securitization chain. He criticized mechanistic reliance on ratings agencies, explaining that their views should be supplemented with analyses of liquidity and of events that could trigger sudden ratings changes, especially for tranche-based instruments. …

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