Blaming models, not frameworks

The New York Times has an entertaining article on the failure of financial risk management today, paying particular attention to the problems with VaR (Value-at-Risk) which is a model used to assess credit and market portfolio risk. It’s interesting to see further attention paid to the fact that these models don’t handle outlier risk at all, yet so many in the industry accounted for them to do that. We’ve apparently learned nearly nothing since Long-Term Capital Management and Amaranth’s meltdowns. The Times writes:

A risk consultant named Marc Groz says, “VaR is a very limited tool.” David Einhorn, who founded Greenlight Capital, a prominent hedge fund, wrote not long ago that VaR was “relatively useless as a risk-management tool and potentially catastrophic when its use creates a false sense of security among senior managers and watchdogs. This is like an air bag that works all the time, except when you have a car accident.” Nassim Nicholas Taleb, the best-selling author of “The Black Swan,” has crusaded against VaR for more than a decade. He calls it, flatly, “a fraud.”

Indeed, it is difficult to handle small probabilities of catastrophic risk, as well as factoring the additive properties in a portfolio of risk. VaR provides no capacity to deal with autocollinearity problems, such as the fact that while many assets may perform in a rather uncorrelated manner at most times, under extreme stress (like a liquidity crisis) their behavior tends to run to nearly complete correlation. At the end of the day, we have to remember that our models are nothing more than approximations of the reality around us, built from the experience of what reality mattered the last time we smacked our head into the wall. Its capacity to serve us through future events is limited to whether the future events mirror the past ones. As advocated earlier, the recurring radicalization and examination of our risk framework and the defined domain of risks is probably an important component in any risk management program.

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