Dr.  Edward  Bace
Middlesex University London

Title: Value at Risk: Lessons Learned

Abstract:

Value at Risk (VaR) estimates potential loss on mark-to-market portfolios, over a stated time horizon with a specific low probability of being exceeded. Probability of loss greater than VaR is usually 1% (99% confidence level) or 2.5% (97.5%). Widespread adoption of VaR as an industry standard was strongly driven by regulation, yet the Global Financial Crisis (GFC) exposed weaknesses in the 1996 Internal Models Approach (IMA) of the Basel Committee on Banking Supervision (BCBS).

This exposition identifies VaR characteristics, illustrating false security of VaR calculations, and makes observations on how to refine VaR going forward. The investigation sources regulatory studies and statistical models to illustrate effects of correlation, time horizon and volatility, which raise problems for VaR. LTCM and the ‘London Whale’ provide egregious examples of VaR failure.

With these drawbacks, alongside the cost and complexity of IMA relating to Fundamental Review of the Trading Book (FRTB), and doubts about capital benefits, it can be surmised that only a few major banks will likely use IMA. Most will use the Standardised Approach (SA). Exponentially weighted moving average (EWMA) estimation, rejected by regulators for capital adequacy, provides a better outcome.

These results could usher in a new era for VaR, giving financial institutions freedom to tailor VaR to their businesses, including potentially a much wider adoption of EWMA VaR.

JEL classification: G1, G2

Keywords: Value at risk; portfolio management; financial institutions; regulation.

Biography:

Edward Bace graduated from New York University’s Stern School of Business, with an MBA in International Finance, and has a PhD from the University of Michigan. He is a Chartered Financial Analyst (CFA) and a Member of The Chartered Institute for Securities & Investment (MCSI). He has worked in professional practice at banks in the US and at S&P in New York and London where he focused on banking, treasury, credit risk and financial analysis, advising firms in a range of industries and countries around the world. He spent fifteen years in Investment Banking heading Credit Advisory at Lehman International in London, and later joined the EBRD and CFA Institute, where he was Head of Education in the region.

Edward is Program Lead and Assistant Professor in the Accounting, Finance & Economics Department of Middlesex University London, teaching corporate finance, banking and risk management, and overseeing Masters’ programmes. He has served on the Independent Standards Committee and Wealth Fund of Camden Council as well as PRMIA’s Ethics Committee. He currently is employed on Editorial Panels for JRMFI, IISES, MDPI and BTRM. He has published articles in Cogent, Securities & Investment Review, Enterprising Investor, Seeking Alpha, Financial Adviser, Professional Investor, Credit Week and CFA Magazine, among others.