Academic Leap

I have been reading some very good academic papers on whether equity capital is really more expensive than debt financing, and thus whether we should be really concerned by banks being demanded to alter their equity-debt mix by reducing leverage. Some financiers say that ehanced equity requirements will sink the economy, as the cost and availabity of credit would become less socially friendly.

Bollocks, say the professors (from top unis). The myth that equity is more expensive is just that, a myth. No bank should have to push loan costs up or reduce lending as a result of tougher capital regulation. And Basel III, publicly portrayed as the proper medicine to the disease of excessive leverage, is not even enough.

I have been surprised by the profs´candor and their brave contrarianism. In one fell swoop, they manage to go at both the regulators and the bankers. But I wonder if they realize the implications that their arguments have in terms of the use of models in finance. Naturally, for the past fifteen years capital requirements have been based on models. These models, not surprisingly, have enabled unlimited leverage and have allowed banks to trot along equity-free. So an argument for equity should automatically imply an argument against said models. And an argument against said models should imply at the very least a very serious rethinking of the overall role of models in finance. Among other things, because the models used for regulatory capital include some of the ideologies and tools held most sacrosanctly by theoreticians. If those models fail (because they inexcusably sanction too little equity) then those ideologies and tools failed. If those failed, what does that say about the discipline of finance theory?

Shuldn´t these profs take the leap from "more equity is good net net, leverage is bad net net" into "theoretical finance has failed us much too much, let´s rethink how we teach and what we publish"? I understand that that may be a contrarian bridge too far (given that the fellow in the university office next door may have devoted an entire career to those failed models, for instance), but it would nonetheless be a very positive development not just in the aid for truth but also from a social point of view (it is obvious to these academics that bank leverage is a horrible horrible thing that causes untold mayhem, so fighting tools that abet the monster should be a good deed, right?).

I have humbly made that leap several times (read chapter 5 in my Lecturing Birds On Flying, or any of my FT articles on the subject, or my recent Yale Economic Review piece). Wouldn´t it be nice if uber-prestigious tenured ivy-leaguers would too choose to leap forward?

Basel, VaR, and Me

Haven´t you noticed how bank regulators have of late taken to badmouthing VaR and fingerpointing it for its role in the crisis? I know, I know, this typically goes uncovered by the media. But for all of us VaR junkies (and I have become one since fully realizing VaR´s responsibility for the catastrophe), it is quite something to witness the BIS, the Basel Committee, the UK FSA, and others basically shout from their rooftops that VaR is and always was crap that would eventually and inevitably lead to perilously lethal toxic leverage in the banking industry.

I know, I know. The mandarins have not gone so far as erasing VaR from the land, but they seem like they would really like to. All those tweakings to Basel´s calculation of the market risk capital charge (a public recognition that the prior system, aka just VaR, was rotten to the core) aim at achieving a VaR-lite regime. It is obvious to me that the add-ons may not solve much, but that´s another issue. What truly matters is the regulatory message: we messed up by embracing VaR all these years, can we make amends?

This must be taxing times for hard-core VaRistas in the risk management and academic worlds. Even their hitherto public-sector allies are jumping ship. What must be even worse for some (like those who lambast my musings with ad hominen attacks, never by addressing the issues) is that quite important regulators now quote from my Lecturing Birds On Flying when looking for supporting arguments in their current "VaR failed" campaign. Some very powerful folks in Basel seem to be saying that that Triana guy actually got something quite right!

Any VaRista out there feeling a bit queasy after reading all this is welcomed to retaliate by posting on the web yet another critique of my book on the grounds that "the style is convoluted" or "the author is unbearably repetitive". Anything but countering the book´s arguments. Especially after even the regulators don´t want to be seen in VaR´s company.

From Jorion-Taleb To Choudhry-Triana

Almost fifteen years after the seminal VaR debate between academic P Jorion and practitioner N Taleb, a much more humble follow-up (courtesy of Financial World mag).

VaR not guilty

Over-reliance on Value-at-Risk (VaR) and a misunderstanding of its statistical accuracy were mistakes made by bank management in the run-up to the crash. However, to suggest that a mathematical measurement tool, as opposed to, say, incompetent management or poor loan origination standards, was a prime cause of the crash is a gross abrogation of responsibility. Pablo Triana (How VaR put banks on road to ruin, FW May) suffers from the same conceptual misunderstanding of VaR that bankers had, and assigns a bigger role to a statistical model than it deserves. VaR was not “invented by Wall Street in the late 1980s” – it was introduced by JPMorgan in 1994. Second, there were two applications for VaR: market VaR and credit VaR. One version used past returns to model the future, but the standard version allowed the user to input the volatility parameter and modify this as it wished. Market VaR is not significantly more inaccurate than modified duration. Triana says VaR treated US Treasuries the same as collateralised debt obligation (CDO) tranches; but it is a simple statistical model and does what it is told. Most credit VaR models use the credit rating transition probability as their main input, so if a CDO tranche is assigned a AAA rating, statistically over the next 12 months it has the same default risk as a US Treasury. Of course, we all know this is nonsense, because a CDO exhibits greater credit risk than a Treasury, so the problem lies not with VaR but the use made of it. Third, and most importantly, Basel rules, not VaR, drive the calculation of bank capital and (indirectly) the level of leverage. Basel 2 allowed regulatory capital to be calculated according to credit rating and, in one version of it, using the bank’s own statistical data. VaR does not impact regulatory capital rules, so blaming it for high leverage of Wall Street banks is unfair, inaccurate and takes the focus away from the real culprits: management. The real problem with VaR, which Triana could have pointed out, was that the most common version (the variance-covariance approach) assumed a lognormal distribution for volatility and was usually calculated at a 90 per cent or 95 per cent confidence interval. Extreme market crashes do not follow a lognormal pattern, and crucially occur with much greater frequency than such a confidence level implies; which is why VaR could never hope to capture severe market corrections. Irresponsibly, senior bank management was frequently unaware of this. Many failed banks, including HBOS, Northern Rock and Bradford & Bingley, did not use credit VaR, at least not exclusively at the expense of other risk measurement methodologies. So their failure must be blamed on something else. Ultimately, one has to look at incompetent bank management.

Professor Moorad Choudhry, London Metropolitan Business School

VaR in the dock

As someone who has been writing financial books for a while, including one on Value at Risk (VaR), I was puzzled by Moorad Choudhry’s letter in the June issue of FW. It misrepresents key aspects of VaR. Contrary to his assertions, VaR was invented in the late 1980s: as has been amply documented by well-known sources, VaR made its formal debut inside JPMorgan around 1989-90, having been conceived and fine-tuned in prior years (in fact, Bankers Trust had developed something similar to VaR even earlier). What happened in 1994, well after the tool had been developed and had begun to be used, is that JPMorgan (through the Riskmetrics conduit) shared its VaR methodology with the world; the main goal of such public release was most likely to entice regulators into embracing VaR as the officially sanctioned risk management and capital-setting tool. VaR is, of course, used for regulatory capital purposes. In 1995, the Basel Committee decided to allow banks to use VaR for the calculation of the market risk capital charge. Such allowance has not been rescinded to this day. In fact, other regulators joined the bandwagon in the meantime, such as the SEC in its devastatingly fateful 2004 ruling that embraced VaR. Choudhry’s comment that “VaR does not impact capital market rules” is simply without foundation. VaR can, and did, lead to poisonous leverage, courtesy of its monumental design flaws. The central question should thus be: why continue using a flawed tool that leads to crisis? Following the path trodden by VaR-defenders, Choudhry skirts the issue and sheepishly blames traders and bankers for misunderstanding poor old VaR. Such nonsense is typically promoted as a way to preserve the tool (and those who measure it and teach it) within financeland. VaR was used exactly the way it was always intended to be used. Are we really expected to accept that those who 1) created the model in the first place, 2) have internally fine-tuned it for two decades, and 3) have spent years lobbying for its adoption by policy-makers, have forgotten that VaR is based on normality, focusing on the selective past and trusting correlations? What Choudhry fails to appreciate is that those supposedly not-understood characteristics are most likely the very reason why VaR was promoted by banks in the first place.

Pablo Triana, author of Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?