RiskMinds – VaR as simple as chartism?
December 11, 2009
Interesting panel debate at RiskMinds Wednesday morning, entitled "Sophisticated Complex Models vs. Crude Robust Risk Measures".
Riccardo Rebonato of RBS started off the debate in (untypically?) controversial style by saying that he thinks that the risk management models (mostly VaR) used in financial markets are peculiar. Peculiar in that coming from a physics background he is used to models that have "causal" links between inputs and outputs, whereas VaR is based simply on the P&L distribution of a portfolio i.e. all the information is contained in the data itself. Riccardo said the obvious analogy was with chartism, where decisions are made on the observed market data itself without any reference to external (exogenous) factors at all (perhaps he should have a discussion on endogenous risk with Jean-Phillippe Bouchard at Quant Invest). Riccardo suggested that in the range of models from those that are "over specified" with two many inputs to those in "reduced form", then VaR was far too much at the reduced form end.
In response to Riccardo's proposal that risk models should involve more causal ("factor") effects, Andreas Gottschling of Deutshe Bank countered with the quote from Harry S. Truman "Give me a one-handed economist! All my economists say, On the one hand on the other.". To which Riccardo acknowledged that maybe Economists and Econometrics were less suited to trading/analyst reports (e.g. give me a single view of what the prospects/returns will be) and more suited to risk management (e.g. give me a range of scenarios with supporting assumptions for each).
Chris Finger of RiskMetrics moved on to put forward an argument for standardisation of risk reporting, saying that it was impossible to say what methodology was behind the VaR numbers disclosed by major financial institutions. He proposed that risk reporting needed to be standardised and obligatory, but emphasised that risk management should not standardised. Paul Shotton of UBS agreed, saying that whilst micro-prudential risk of Pillar I had decreased risk on an individual institution level, it had increased systematic (macro) level risk and this was an area of failure for the regulators. On this the panel agreed, echoing a lot of what Avinash Persaud said in proposing the more diversity of risk management was highly desirable.
On standardisation, Riccardo noted that many banks had switched from using 10-day to adjusting up a 1-day VaR, and as a result presenting a less risky picture to analysts and regulators, regardless of how risky the "tail" of each institutions' P&L distribution is. Riccardo also proposed that there should be "constructive ambiguity" over what is asked of the banks by the regulators – put another way he suggested the regulators should come up with the "curriculum" for risk but not the "questions", as definitive questions encourage arbitrage.
Andreas then brought the debate back to its title, and put forward that maybe VaR should be replaced by simpler measures such as limits on notional traded. Paul suggested that VaR was only good for simpler products and portfolios, under "normal" market conditions. He said that he had been an advocate of more stress testing for a long time as a complimentary approach to VaR, but also combined with the simpler approach of limits.
It was an interesting debate, particularly with Riccardo's proposal on VaR being too simple a measure based on statistics, and wanting a more "causal" model to be developed. Using the example of June 2007, Riccardo said that everyone knew something big was about to happen but this was not reflected in VaR calculations since they are statistically based and inherently backwards-looking and not predictive. The lack of prediction is a very valid point, but putting forward a counter-view, then I get the argument about economists giving a range of outcomes, but surely these should be fed into the scenario engine rather than trying to develop econometric models of relationships between market variables. Econometric models are just as vunerable as any other to the mis-behaviour of markets (anyone seen a stable correlation lately?).
A few of the other risk managers there expressed other views, from the more buy-side folks who were more comfortable with factor-based modelling, to risk managers who said that VaR was already "structural" with explicit relationships between valuations and interest rate inputs for example. It would be good to understand more of Riccardo's ideas on this, since it appeals from making risk a more "forward-looking" process but I find it difficult to quite grasp what "causal" model you can have of markets that is itself robust to changes in market behaviour.