Author and specialist financial derivatives Nassim Nicholas Taleb was recently quoted extensively in a New York Times article titled “Risk Mismanagement”. He makes some valid points with regard to the usefulness of risk metrics at times of extreme market behaviour. But while VaR certainly has its laundry list of problems, Taleb takes VaR out of context by focusing on only one version : the Gaussian-based parametric VaR which he rightly points out is severely constrained by the dangerous assumption that asset returns follow a normal bell-shaped distribution.
In fact, he even goes so far as to say that VaR was highly responsible for the current financial crises. This is rather disturbing, as his claims seem to have gained a wider currency, thus detracting from the infinitely more important issues behind the crisis. If we look back in history, we can see quite clearly that most “blowups” were not due to poor allocation decisions based on an over-reliance on risk measurement and optimisation models, but were about leverage, unchecked greed, operational disaster and outright fraud.
While VaR is a requirement for a bank, most traders and fund managers would laugh if you asked them if they took VaR very seriously. The reality, alarmingly, is that risk managers have hardly any clout when it comes to strong-arming a trader or liquidity.
Risk manager warnings are often ignored or overridden as senior management tends to focus purely on profitability, not risk. This is not a risk model problem, but a corporate governance problem. Instead of bashing risk managers, we should be giving them more independence, capabilities and authority to identify and limit excessive risk-taking.
Long-Term Capital Management (LTCM) was leveraged 100x at one point and Bear Stearns’ credit hedge funds over 40x. A simple cap on gross exposure would have helped to avoid the problems they encountered with leverage. Of course, this would have interfered with a strategy that depended heavily on leverage to boost minuscule returns.
