Wednesday, October 17, 2012

The scam that is Value at Risk

On his blog, The Big Picture, Barry Ritholtz looks at what he calls the scam that is Value at Risk and presents the argument that doing away with VaR would result in knocking out the prop that supports the Too Big to Fail banks and would in turn result in their being broken up.

Regular readers know that the prop that supports Too Big to Fail is bank capital requirements: specifically, Basel I, II and now III.

The capital requirements are designed to provide the necessary opacity to let banks increase their leverage.

Value at Risk is simply window dressing to suggest that the risk of all this leverage is under control.

Fascinating quote from Nick Dunbar, author of The Devils Derivatives
“What would happen if VaR was taken out of bank regulation? Immediately, the intellectual crutch for highly-leveraged complex banks would disappear. Deprived of their fancy radar screens, regulators would have break up large banks that they could no longer pretend to understand, while increasing their capital to the level of a typical hedge fund.” 
In other words, VaR’s sole purpose was not to actual help with risk management, but to fool the regulators that banks could rely on their own models to (wait for it) manage their own risk. 
Make them smaller, reduce their leverage, and do, as FDIC vice Chair Thomas Hoenig suggested, turn them into utilities.

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