Value At Risk Models And The Volcker Rule

by Sean Bryant on January 21, 2014

Volcker ruleThe repeal of Glass-Steagall in 1999 opened the floodgates for what is sometimes referred to as the “new science of risk management.” Value-at-risk models, or VaR, describe measures financial institutions use to determine potential loses in a given time period. Risk managers give traders an upper limit they can possibly lose on a particular endeavor on any given day in hopes of turning a profit in the long-term.

For instance, in a parametric Delta Normal VaR model, the daily performance of a trade is tracked to determine its volatility — or the standard deviation of the data — based on the risk manager’s chosen confidence level. Thus VaR (percent confidence) in this instance equals the critical z value of the data plotted on a normally-distributed bell curve multiplied by the standard deviation. The main problem with this model, however, is the data are simply assumed to be normally distributed, even though they are not. The problems with VaR extends far beyond even that point, however.

Value at Risk Failures And Dangers

Chase CEO Jamie Dimon was forced to testify in front of the Senate Banking Committee in June of 2012 after America’s largest bank lost upwards of $6 billion in one month via a failed hedge. The hearing was meant to reprimand Dimon and potentially start discussions about more regulations to curtail these incidents.

Senator Bob Corker, R-Tenn., asked Dimon if Dodd-Frank financial reforms of 2010 are enough to stop this kind of reckless behavior. Though it took three times asking the same question, Dimon finally responded “I don’t know.”

The Financial Times reported this past June that volatility in U.S. and Japanese bonds could completely unravel all banks’ VaR models. Denny Yu, of risk analysis company Numerix, said a mass sell-off of bonds similar to the 2003 “VaR Shock” is highly likely for institutions relying solely on VaR models to determine risk.

The Volcker Rule

The U.S. Securities and Exchange Commission recently stated it does not have all the tools and statutory powers necessary to enforce a provision of the Dodd-Frank Act called the “Volcker rule.” Named after the former Federal Reserve chief, the main purpose of the Volcker rule is to stop financial institutions from acting as both creditor and advisor simultaneously. It separates the investment and proprietary trading arms of an institution from its consumer banking arm (similar to Glass-Steagall). The rule also forces financial institutions to provide extensive reports outlining their VaR models.

Mark Zandi, chief economist for bank stress testing and economic forecasting company Moody’s Analytics, told Bloomberg in 2012 that he is not a fan of the rule and believes it will be difficult to enforce productively. The American Banking Association said in 2012 that it would take more than 8 million man-hours and 3,000 employees to implement and enforce the rule. The costs will most likely be passed on to the consumer via higher fees and interest rates. The Volcker rule takes effect at the end of June for all banks with more than $50 billion in assets.

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Sean Bryant

Sean Bryant created in 2011 to help pass along his knowledge of finance and economics to others. After graduating from the University of Iowa with a degree in economics he worked as a construction superintendent before jumping into the world of finance. Sean has worked on the trade desk for a commodities brokerage firm, he was a project manager for an investment research company and was a CDO analyst at a big bank. That being said he brings a good understanding of the finance field to the One Smart Dollar community. When not working Sean and he wife are avid world travelers. He enjoys spending time with his daughter Colette and dog Charlie.

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