Full steam ahead to a new beginning

This blog post originally appeared on FOW.

The rapid response to the financial crisis initiated by the G20 has led to a plethora of new regulations which sometimes seem like a never-ending series of sticky plasters trying to patch up a leaky hull. No sooner has one leak been fixed (think Stressed VaR or Incremental Risk Charge) than another springs forth (think CVA or Wrong-Way Risk). Inevitably in times of crisis and emergency this approach is needed to steady the ship, but shouldn’t we also be trying to steer a course to a safe harbor?

This seems to be the thinking behind the Basel Committee on Banking Supervision’s latest consultation document entitled “Fundamental review of the trading book.” The aim of this review is to set a consistent framework within which to think about regulatory capital and, despite the name, it touches upon the banking book as well as the trading book.

The suggestion that will inevitably grab the most headlines is the proposal to replace VaR (Value at Risk) as the main measure of market risk with ES (Expected Shortfall). Although controversial, this has many practical and theoretical advantages. The main stated benefit is that whereas VaR provides a lower bound on extreme losses (“you’ll lose at least this much, but we can’t say how much worse it could get”), ES tries to quantify what dangers lurk in the tail of the loss distribution (“this is the average of the really bad losses”).

However since ES relies on much the same simulation framework as VaR, it still suffers from some of the other drawbacks, such as the assumption that looking into the past can tell you something about the future. Also, back-testing ES (i.e. trying to judge whether your model is in fact good at predicting the future) is a lot more complex than back-testing the simpler VaR concept.

Some other proposals, such as introducing liquidity assessments into market risk measures, seem particularly prescient in the light of recent multi-billion dollar trading losses in illiquid credit default indices. However it seems unlikely that the traders taking on those positions didn’t know that there was finite liquidity available, and so the question is whether or not a liquidity indicator would have led to risk management overruling the trading desk’s strategy.

Probably the most significant proposals from a long-term perspective surround the boundary between the trading book and the banking book. One of the major issues of the financial crisis was the ability of banks to arbitrage between the two books; the tightening up of rules about where assets are accounted for can only help. Since interest rate risk is a pillar 1 item for the trading book but a pillar 2 item for the banking book there is more work to be done, but getting a comprehensive and consistent framework across all areas of risk is one way to ensure our banks weather future storms better than they managed the recent ones.

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