Regulation and Risk Management: Value-at-Risk as a Unifier
Innovation is giving rise to an increasing number of regulations because of, or in some cases leading to, new risk management techniques. If the Basel accord is a result of a need to think about credit risk, market risk and operational risk, regulatory measures like Check 21 produce a need to think about fraud management. PayPal is emerging as a rival to the credit cards in payment processing. However it necessitates guarding against the issue of fraud management.
Risk managers and regulators may find solace in the unifying nature of the concept of value-at-risk (VaR) that answers risk management as well as regulation in a manner alike.
VaR is a promising concept that in simple terms means the maximum value that is at the risk of loss in a given period of time with a certain probability or confidence level. The value could be the actual currency amount (say, in dollars). Time is usually a short period such as a day or a week at the most. Probability is expressed in percentage terms, absolute. Calculation of VaR makes use of simple maths and statistics. For those who do not find maths to be their cup of tea, VaR is the standard deviation (SD).
What is SD? Given a column of numbers, anybody can find the average/ mean. Variance of each number from the mean is the square of the difference between the mean and number. Sum up all such differences and there comes the variance of the distribution (or call it the column of numbers). Standard deviation is the square root of this sum. The column of numbers in VaR could be numbers related to any of the following:
VaR can be used to estimate loss on a portfolio – debt instruments (bond return), equity instruments; trading revenues; derivatives, foreign currency spot positions, to name a few from the list.
There are three different methods of calculating VaR based on correlations, distribution patterns, volatilities etc:
When a manager gets an estimate of loss on her portfolio, it makes decision-making and portfolio management easier. This further makes things fall in place, which ensures compliance to the regulation.
Besides, the various regulatory measures talk of impeccable standards by wrapping simple common sense in complex jargon. For example, the single feature that stands out in the Basel accord is capital adequacy for the banks/ financial institutions. Financial institutions should have sufficient capital (with or without Basel) to protect their depositors and counterparties from on- or off-balance sheet risks. VaR helps assess an institution’s capital adequacy and allocate capital to its different operations. Capital charge is estimated as the higher of the previous day’s VaR, or three times the average of the daily VaR of the preceding 60 business days. Hence VaR facilitates the goal of regulators to initiate strategic balance sheet management. The Sarbanes-Oxley Act of 2002 aims at financial accounting reforms by promoting financial integrity, data transparency and internal control.
The origin of regulatory measures can be traced back to corporate debacles. Derivatives trader Nick Leeson (1995) was responsible for the $1.3bn loss of the 233 year-old Barings Bank, London. The bankruptcy tale taught several lessons in financial risk management. The Enron accounting scam (2001) unfolded the billion-dollar fraud under its then CEO Kenneth Lay. Sarbanes-Oxley (2002) then came into being making it mandatory for the chief executives to sign the accounting statements.
Another accounting bankruptcy took place in 2003 when Italian food giant Parmalat went into insolvency. The loss is estimated to have reached a whopping $23bn as of January 2004.
The regulatory initiatives have thus been more reactivethan proactive in nature. In fact this becomes one of the major reasons for leaving a large scope for birth of new regulatory measures. To err is human. It needed a perilous error on September 11, 2001 to sign laws for safety/ security measures including USA PATRIOT (Unifying and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism) Act in October 2001.
VaR tends to leave its trail as a proactive tool for risk management. At the end of the day, the regulators’ intention is to provide suitable laws for risk management. An organisation’s performance can be compared against the set VaR limits for trading operation. It shows whether the risk has been over- or under-estimated. VaR also facilitates the measurement of the organisation’s operational risk sensitivity with respect to changes in interest rate or foreign exchange rates.
Estimate the volatility of net interest income and net portfolio value by using the required confidence levels on different interest rate scenarios. This is VaR in asset-liability (gap) management. Portfolio managers along with investment managers or private bankers may use VaR to set risk limits on their portfolios. Needless to say, all the above applications of VaR contribute in one way or the other an effective mechanism towards steering the regulatory reforms.