The VaR cover-up

October 14, 2009

By Pablo Triana

Pablo Triana is the author of Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets? The views expressed are his own

Last month, several men and women assembled in a somber room in Washington to discuss one of the key issues (in my opinion, the key issue) behind the financial crisis that has caused so much misery.

Among those gathered were leading politicians and top financial professionals. A world-renowned bestselling author was there, too. You might think that the media would have devoted attention to such an important event. Surely journalists wouldn’t want to miss the opportunity to report on a roundtable of policymakers and experts that promised to tackle the true factors behind the mayhem, right?

Wrong.

The historic hearing convened by the House Committee on Science and Technology on the responsibility of mathematical model Value at Risk (VaR) for the meltdown has received essentially no coverage. A couple of informed bloggers here and there have shared the news, but the silence from the mainstream behemoths has been deafening.

This is outrageous. Bluntly stated, you can’t talk about this crisis without talking about VaR. Can you imagine a reporter covering the fraudulent accounting crisis that afflicted America a few years back and not covering the Enron hearings on Capitol Hill?

The silence by the media when it comes to VaR has been accompanied by silence from policymakers and bankers. The former (with the notable exception of the FSA of Britain) may understandably wish the debate not focus on how badly a tool they wholeheartedly embraced for years has performed. And the latter (some of them at least) may resent the badmouthing of a tool they themselves invented and that has worked wonders for many a trader.

Rather than humbly recognizing that they chose the wrong beacon to measure market risks and to set gearing-determining capital requirements (VaR gravely underestimated the former and churned out ridiculously low numbers in the latter), mandarins and bankers have forged a coalition of the mute, apparently unmoved by all the destruction that VaR has enabled. They seem content with the sight of pundits blaming everything but VaR for the destruction.

The silencing efforts of all those powerful constituents makes it impossible for lay people to get to grips with an unavoidably essential part of the story behind the crisis. In effect, the link between VaR and the troubles has been hidden from view. That is a pity and not just because the public would be rendered hopelessly misinformed. By not focusing the debate on VaR, the silencers go a long way towards contributing to a repeat of the cataclysm down the road.

The Congressional hearing was a brave attempt to shed light on this mysterious highly influential force that should stop being mysterious. Lawmakers are right to question VaR since the No. 1 reason the model was allowed to cause so much damage is that regulators endorsed it. Had the Securities and Exchange Commission, not embraced VaR in 2004, the crisis may well have not happened.

VaR should stop being used as the tool that calculates capital charges; if banks want to use it internally for risk management purposes that’s their business, but clearly those paid by taxpayers should not go on adopting and enforcing a machine that has cost so much money to so many taxpayers.

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