In Print: Volume 87: Number 6
By Peter Conti-Brown
87 Wash. U. L. Rev. 1461 (2010)
Accurately and precisely modeling financial risk is something of a Holy Grail for financial theorists, regulators, and market participants. But like the Holy Grail, the location of a comprehensive model of risk remains unknown; some have even suggested that such a model is a figment of financial theorists’ imaginations.
Nowhere has that disaster been more fully evident than in the recent failure of risk models to adequately prepare the marketplace for the collapse of the market for mortgage-backed securities and credit derivatives, and the financial crisis that followed. Because of the mistaken assumptions associated with some risk models, otherwise vigilant market participants were blinded to the risks that brought the global financial system to the brink of collapse.
One of the modeling critics’ primary targets is the Value-at-Risk (VaR). In the 1980s, practitioners created a model to focus on the risk exposure experienced by a single firm. VaR is meant to give traders—and, eventually, investors and regulators—a snapshot of how much money a firm might lose in a single day. That dollar figure is easy to comprehend and straightforward in its application; if a firm is uncomfortable with that exposure, the firm can make appropriate adjustments to its trading strategies and positions. As VaR continued to develop, traders and academics weren’t the only ones paying attention. Soon, regulators from the U.S. Federal Reserve, the U.S. Securities and Exchange Commission (SEC), the Basel Committee on Banking Supervision, and the UK Financial Supervisory Authority endorsed it as an adequate tool for setting banking capital adequacy requirements, and for appropriate risk disclosures to shareholders.