From MoneyBeat (Jul. 1):
How risky do you want your bank investments to be? Don’t laugh, it is a serious question.
These days, investors can adopt a buffet-style approach to bank risk. To get a sense of what is on offer, take a look at the table accompanying this column.
It is an attempt by Fitch Ratings to get an apples-to-apples comparison of banks’ “value-at-risk,” or VAR, the most common yardstick of trading risk. VAR is designed to measure the maximum trading losses faced by a bank in a single day.
So if you fancy a bank that takes big bets on equities, Goldman Sachs Group Inc. was the one for you in the first quarter, according to Fitch. Want a Wall Street firm that swings big on commodities? Look no further than Morgan Stanley MS -0.67%. If foreign exchange is more your thing, do consider Citigroup Inc. C -1.02% But if it is interest-rate and credit risk you crave Bank of America Corp. BAC -1.11% could be an ideal choice.
Risk is inherent in any investment, and a high VAR needn’t be, in itself, a bad thing. It actually could signal that a bank is a better trader than its rivals. But the issue for investors, regulators and bank executives is whether they can properly monitor the risks large institutions take in the markets.
This isn’t an academic exercise for risk nerds. The inability to assess, and price, trading risks was a significant factor behind the huge losses sustained by banks during the financial crisis. As monetary and economic uncertainties push markets into a new period of turbulence, is the system better prepared?
It doesn’t look that way. There are two fundamental deficiencies in the way banks report their stance on risk: transparency and consistency. The result is that it is nearly impossible for an outside observer, be it an investor or a regulator, to compare trading risks across banks....MORE
HT: Riskology who writes-
The Most You Can Lose?
In yesterday’s Wall Street Journal, there’s an article entitled Tracking Risk Isn’t So Easy that overall is a solid description of some of the problems with measuring risk and comparing quantitative risk levels from one firm to another. The article is worth reading because it redeems itself quite nicely despite a major blunder early on. You’d think that an outfit like the Journal wouldn’t make a rookie mistake in one of the first few paragraphs where they wrote: “…value-at-risk, or VAR,[is] the most common yardstick of trading risk. VAR is designed to measure the maximum trading losses faced by a bank in a single day” (my emphasis). Wrong. Very, very wrong. Believing that VaR measures the most you can lose is a mistake that reveals just how misunderstood risk management is, even by experts at the WSJ.
What if someone asks for the risk of a river overflowing and flooding a city? One response might be a statistical analysis to calculate the “Floors-at-Risk” or FaR. I can just image the deadlines: “This month’s flood had a FaR of 2.5″, and the article would go on to explain that meant experts expected water to rise to 2 1/2 floors before receding. Would anyone ever suggest that the FaR number is the highest the water could ever get to? Of course not! Everyone understands that water can rise much farther than the expected level. It’s pointless to talk about the “maximum possible height” of the water. What matters is the associated likelihood of each possible water height, with the expectation (and hope!) that the likelihood drops off quickly with increasing height.
The Value-at-Risk number is similar: it’s an estimate of how bad things can get most of the time, with the same expectation of diminishing likelihoods for bigger loses. VaR is certainly not the most you can lose. In just about every case involving “plain vanilla” securities like stocks and bonds, the most you can lose is everything: 100% of your investment (in cases of derivatives, you can actually lose more than that amount). So thinking about the most you can lose is not really informative – rather, risk managers talk about the probabilities associated with losing various amounts....MORE
