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Originally Posted by matfx

Bubble Value At Risk : Extremistan And Procyclicality



This is a story of the illusion of risk measurement. Financial risk management is in a state of confusion. The 2008 credit crisis has wreaked havoc on the Basel pillars of supervision by highlighting all the cracks in the current regulatory framework that had allowed the credit crisis to fester, and ultimately leading to the greatest crisis since the Great Depression. Policy responses were swift--UK's Financial Services Authority (FSA) published the Turner Review which calls for a revamp of many aspects of banking regulation, the Bank of International Settlements (BIS) speedily passed a Revision to its Basel II, while the Obama administration calls for a reregulation of the financial industry reversing the Greenspan legacy of deregulation. The value-at-risk risk measure, VaR, a central ideology for risk management, was found to be wholly inadequate during the crisis. Critically, this "riskometer" is used as the basis for regulatory capital--the safety buffer money set aside by banks to protect against financial calamities. The foundation of risk measurement is now questionable.

The first half of this book develops the VaR riskometer with emphasis on its traditionally-known weaknesses, and talks about current advances in risk research. The underlying theme throughout the book is that VaR is a faulty device during turbulent times and by its mathematical sophistication misled risk controllers into an illusion of safety. The author traces the fundamental flaw of VaR to its statistical assumptions--of normality, i.i.d. and stationarity--the "gang of three". These primitive assumptions are very pervasive in the frequentist statistics philosophy where probability is viewed as an objective notion and can be measured by sampling. A different school of thought, the Bayesians, argues for subjective probability and has developed an entire mathematical framework to incorporate the observer's opinion into the measurement (but this is a subject matter for another publication). We argue that the frequentist's strict mathematical sense often acts as a blinder that restricts the way we view and model the real world. In particular, two "newly" uncovered market phenomena-- extremistan and procyclicality--cannot be engaged using the frequentist mindset. There were already a few other well-known "market anomalies" that tripped the VaR riskometer during the 2008 crisis. All these will be detailed later.

In Part IV of the book, the author proposes a new risk metric called bubble VaR (buVaR) which does not invoke any of the said assumptions. BuVaR is not really a precise measurement of risk; in fact it presumes that extreme loss events are unknowable (extremistan) and moves on to the more pressing problem--how do we build an effective buffer for regulatory capital that is countercyclical, and that safeguards against extreme events. This book is an appeal (as is this preface) to the reader to consider a new paradigm of viewing risk--that one need not measure risk (with precision) to protect against it. By being obsessively focused on measuring risk, the risk controller may be fooled by the many pitfalls of statistics and randomness. This could lead to a false sense of security and control over events which are highly unpredictable. It is ultimately a call for good judgment and pragmatism. This book is intended to reach out to the top management of banks (CEOs and CROs), to regulators, to policy makers and to risk practitioners--not all of whom may be as quantitatively inclined as the specialized risk professional. But they are the very influencers of the coming financial reregulation drama. We are living in epic times and ideas help shape the world for the better (or for worst). It is hoped that the ideas in this book can open up new and constructive research into countercyclical measures of risk.