Felix Salmon

Idea of the day: Replacing VaR with leverage ratios

By Felix Salmon
September 10, 2009

For all that Rick Bookstaber has taken potshots at Nassim Taleb in the past, his testimony today in front of the House committee on science and technology ultimately ends up in pretty much the same place as Taleb’s does.

Here’s Taleb:

Leverage is a direct result of underestimation of the risks of extreme events –and the illusion that these risks are measurable. Someone more careful (or realistic) would issue equity. April 28, 2004 was a very sad day, when the SEC, at the instigation of the investment banks, initiated the abandonment of hard (i.e. robust) risk measures like leverage, in favor of more model-based probabilistic, and fragile, ones.

And here’s Bookstaber:

There are two approaches for moving away from over-reliance on VaR.   

The first approach is to employ coarser measures of risk, measures that have fewer assumptions and that are less dependent on the future looking like the past. The use of the Leverage Ratio mandated by U.S. regulators and championed by the FDIC is an example of such a measure. The leverage ratio does not overlay assumptions about the correlation or the volatility of the assets, and does not assume any mitigating effect from diversification, although it has its own limitations as a basis for capital adequacy.

Happily, I think they’re both likely to get what they want: the G20 seems determined to move to simple measures of capital adequacy, rather than the failed, complex measures which were embedded in Basel II. How long that will take, however, is unclear: bank regulation moves slowly at the best of times, and slower still when the changes are big.

5 comments so far | RSS Comments RSS

I don’t think it’s entirely fair to call Basel II “failed”. Clearly it was inadequate, but that’s not the same thing. I say this for two main reasons:

1) Basel II had only just been introduced when the credit crisis hit, and in fact was still being phased in in most countries. It’s hard to say what the overall effect would have been had it been in place during 2002-2007. Obviously, though, it wouldn’t have done anything about the problems of underestimating the risk of super senior CDOs.

2) In some ways, Basel II is a lot better than the (pre-crisis) US approach. Take ABCP conduits, for instance, one of the big problems in the early days of the crisis. Under Basel I and the US system, eligible liquidity facilities to ABCP conduits are dirt cheap, capital wise. Under Basel II, they’re effectively the same as holding the assets on balance sheet. Now, this wouldn’t have stopped the SIV problem, because those had very small committed liquidity facilities, but it would have made a big difference to the early stages of the crisis had it been in place before then.

Posted by Ginger Yellow | Report as abusive

Felix: Do yourself a favor and stop paying attention to taleb

How do you adequately penetrate the many layers of leverage hidden away off-balance sheet exposures and derivatives without dealing with the same sorts of issues a VaR analysis would require?

I also fail to see how you can safely ignore correlation. If you borrow short to invest long aren’t you taking a lot more risk than borrowing long to invest long? So much for “robust”

Posted by thruth | Report as abusive

“One of them, which I have written about repeatedly, is the liquidity crisis cycle. An exogenous shock occurs in a highly leveraged market, and the resulting forced selling leads to a cascading cycle downward in prices. This then propagates to other markets as those who need to liquidate find the market that is under pressure no longer can support their liquidity needs. Thus there is contagion based not on economic linkages, but based on who is under pressure and what else they are holding. This cycle evolves unrelated to historical relationships, out of the reach of VaR-types of models, but that does not mean it is beyond analysis.”

I called this a Calling Run because I’m no expert. But this is a central insight to understanding this crisis, and what happened after Lehman.


It isn’t leverage ratios, VaR risk modelling, or Basel III that is going to open the liquidity spigots. It is evidence- from real, non-financial, economic players – that they have sufficient risk visibility and management control to drive through the economic storms and create confidence/Credo/credit.It is disheartening to hear regulators, Bankers and many in the media focusing on the ’causes’ and top-down solutions.As, for many years, a reinsurance underwriter of real events, I have witnessed the LLoyds LMX spiral of the 1980′s,insurance deregulation globally creating the vogue for 100% risk cession to reinsurers in Bermuda/London with the associated drop in underwriting standards and greater reliance on modelling for natural hazards with dire consequences for some. These events mirror- on a much smaller scale admittedly – structural issues of capital flows, who-holds-what-risk and poor ‘front-end’ underwriting quality that are the subject of daily debate.History will tell us that complex networks are as weak or as strong as individual nodes within them at any real-time’ moment – not based on 30-90 day old risk information as many models use. Our grandparents fought for self-determination and yet we have used this gift to outsource responsiblities to many service providers who may have insufficient understanding of their true risk position for the sake of what?. Human judgement -for the forseeable future – still has a role to play next to ‘artificial intelligence’. To paraphrase Warren Buffett, it is dangerous to drive using the rear-view mirror; we must begin to rely on our own eyes and our own reliable risk information to navigate the road to economic recovery.
PS Taleb is a skeptical empiricist – he doesn’t pretend to have all the answers – surely that is a realistic and commendable position to take?


Let the banks disclose as much data as the life insurance industry, and let them do the harder stress tests that valuation actuaries do. That would be a good start.


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