GAFM Articles

GAFM Articles > > Risk Management > The Value of Risk and the Value at Risk

The Value of Risk and the Value at Risk

By Michael Vincent

26 December, 2006

The Value of Risk and the Value at Risk

Recognising Duration and Risk Management

The Risk Management Paradigm for the Banking Community

Have you wondered why the words ‘risk management' are heard so widely today?  Have you considered what can be achieved with an understanding of the term?  Indeed, is the term used or misused in today's banking community?

 

As Peter Bernstein showed in his history of risk, Against the Gods, risk became an acceptable term when the vast majority of people decided they could control their own future, and that God did not preordain every facet of human life.  Thus began the struggle to identify and manage risk.  Along the way risk has come to be many things to many people: from finance; to insurance; to occupational health and safety; to engineering tolerances; and all points in-between, this facet has lead to considerable anguish in the financial world.

 

In the past, banks had the luxury of employing large numbers of people in middle management positions.  These managers ensured the needs and wants of the organisational design were met in all ways sometimes subliminally.

 

By having a large management structure that was used for checking and ensuring compliance, risk was contained and controlled in a simpler and more structured world.

 

The winds of change started to sweep the financial community in the late 1970's and continue to this day.  Competitiveness, efficiency and productivity have become the by-words of today's business environment.  Any country or business that ignores the pressures generated by the forces of change is only delaying the inevitable.

 

One of the more significant outcomes of the change process over the last decade is the virtual elimination of the middle management ranks that had grown to an enormous size since the end of the Second World War.  Without middle management, how can a business be effectively controlled?  That is the question that must be answered for financial institutions to survive and prosper into the future.

 

Developed countries and business have made great leaps over the last decade but must continue to change and adapt for us to keep our regional advantage.  Understanding risk management and applying the principles of risk management.  However, a new paradigm must be accepted and adopted.  Bankers have a duty to contribute to the development of risk management as a recognised and separate business discipline that enables a financial institution to chart its future in an effective and orderly way. 

Banking has become much more systematic than in the past the drive for share holder value in the absolute thrust of today's larger banking groups, they are trying to unlock value by massive restructuring.  One of the offshoots of the process is the increased risk and volatility of the system.  Banks face a wide variety of risks in the day-to-day operation of their business, not including staffing and physical issues, chief amongst these are:

 

Interest rate riskCredit riskMarket riskForeign exchange riskLiquiditySolvency

 

Interest rate risk is currently the predominate risk, although as the mix of banking changes so will the degree of order of the risks.  Interest rate risk is the risk of adverse price movements of a security due to changes in interest rates.  Duration, a tool to measure the exposure is a gauge of a security's exposure to interest rate risk. It measures the time flow of cash from a security.

 

In other words duration is the effective maturity of a security because it can account for the interim cash flows.  Traditionally duration as a risk management tool has focused on bond portfolios but financial institutions are casting a wide net for risk management tools. Duration, value at risk, liquidity at risk and the recognition of the value of risk are various techniques for recognition of the risk profile of a bank's balance sheet.

 

In recent years, risk has become a vital issue for financial institutions management; its successful identification and mitigation will more and more separate the market leaders from the also-rans. In the context of financial institutions, risk is defined as "the adverse impact of profitability of several distinct sources of uncertainty." 

 

Duration is an instrument to measure interest rate risk.  Frederick Macaulay first developed it in 1938, originally it was seen as a better way to summarise the timing of bond flows than the measure of term to maturity.  Duration relates the percentage price change of a security to a single property of the income stream.   Today, duration is widely applied to the asset and liability scenarios of financial institutions, effectively it is seen as an alternative to gap management, (the monitoring of interest rate sensitivities and maturities of assets and liabilities.)

 

Comparing the balance sheets of various international banks, assets in general have a duration much longer than the average liabilities.  Accordingly long terms assets are financed by short terms liabilities.  This is due to the inherent characteristics of individual securities, i.e. the predominant assets are loans and mortgages, which have long durations. On the other side of the balance sheet the majority of liabilities are comparatively short term.  This can be an advantage in a falling interest rate environment, however if interest rates rise the market value tends to decrease, financial institutions are exposed to volatility in a way that can lead to large accumulated losses.  We are in an environment of upward moving rates in the western world with some saying they have peaked, however I believe we have at least another year before the pressure is off.

 

The lesson is, if financial institutions have a certain idea of the direction of movements in interest rates, it can apply duration strategies to optimize the asset and liability portfolios according to the expected changes.

 

There is a large and varied discussion revolving around the application of Value at Risk (VaR) that is worth summarizing here, the point to note though is very little time or thought has gone into the value of risk.  We are very busy placing a negative thrust to the management of risk and applying methods to manage or minimise the perceived risks but few are looking at the positive side of the equation.  In banking terms we must see a traditional full service bank as a risk attacker, the perception in the community is that banks are safe and secure.  This is simply not so, a successful bank is one who accepts corporate risks, off-lays and/or manages them for a profit.  Therefore banks must accept the principle of the value of risk and apply that principle through its risk management process.  This process may involve analysis of Value at Risk, Economic Value Added, Liquidity at Risk or some other model depending on the methodology used by the individual bank.

 

In this article I will avoid the use of formulae or graphs and rely on word pictures to simplify an often over complicated issue.

 

Risk is the unexpected happening or more correctly in banking terms the degree of uncertainty surrounding future earnings.  Uncertainty becomes the central theme of the equation and risk is extended by type and severity.  The concept of VaR is central to effective risk management.  Value at Risk is a measure of the maximum potential change in the value of a portfolio of a financial institution's instruments with a set probability over a pre-set time horizon.

 

Finance theory strives to measure risk and its impact on financial institutions, securitisation has been the driving force in the need to understand the volatility of the portfolio under management and the consequent impact on the health of the bank or institutional balance sheet.  The main advantages of VaR as a management measurement tool are:

 

Utilises a short forecast horizon of market variables andUniformly adopts mark to market

 

VaR requires the institution to have all positions marked to market and future volatility and variability values estimated.  In other words VaR is simply part of a suite of risk management methods.  The real value of VaR is that it aggregates several components of market risk into a single understood number by examination and analysis of:

 

Normal market conditionsSpecified time horizonProbability of event occurrenceMeasure unit applicable

 

In practice there are different models, with wide and differing assumptions and different methods of calculation that produce a wide variety of results.  In practice one must define the application and methodology and ensure a wide understanding of the method so that the results cannot be skewed by a lack of understanding.  Some of the limitations of the practice are:

 

Concentrates on a single and at times arbitrary pointMust be recognised as a statistical measure, that needs interpolationDifficult to apply the concept of uncertainty, ie difficult market conditions.

 

In calculating VaR four broad and several underlying approaches or methods can be identified:

 

1. Historical:Define and list market factorsCollect values for periodCalculate the change from period to periodCreate a selection of alternative values by analysis of current values of observed changes over timeSelect current or present value over alternative selectionsSort from highest to lowestVaR is then calculated utilising the desired confidence interval.

 

2. Hybrid:The most recent return assign a weightingList in ascending orderUse linear interpolation - start from the lowestCombine approaches

 

3. Simulation:Sort instruments in order of complexity by market factors or factorCollect information for a given portfolio periodSmooth out period by periodObtain the portfolio distributionFrom above VaR is able to be calculated

 

 

 

4. Cash methodology:

 

Can be earnings at risk, solvency at risk or the most popular cash flow at risk. Many methods of calculation

 

Underlying approaches:

 

a. Closed form value at risk:Used for simple portfoliosAlso called parametric or delta-normalIt assumes that the portfolio is normally distributed and will behave linearly with applicable risk factorsCalculations based on volatilities and correlations of applicable risk factors.Can be used for portfolios like spot or forward foreign exchange positions or short term debt instrumentsWill not work in portfolios that contain options, structured notes or mortgage-backed securities.

 

b. Delta-Gamma value at risk:Utilise quadratic assumptions instead of linearity assumptionsThis will incorporate second order sensitivities into the equation, this enables the model to be more complex and creates applicability for a wider range of portfolio applicationAgain not fully applicable to options or exotic derivatives

  

c. Monte Carlo value at risk:For use in complex portfoliosWill produce constant precise results for portfolios that have a significant gamma or convexity.

  

 

We can now define VaR a little more precisely, a good definition was proposed by Beckstrom and Campbell in Introduction to VAR, "VAR is the expected minimum loss in currency units over some time interval for some level of probability selected by the portfolio manager.  The questions that need to be asked are: 1. How much money might we lose?  2. Over what period?  3. What is our confidence level or probability of event occurrence?

 

In a financial institution the mere identification of VaR may not be a full measure as it may only identify the value of various portfolios in isolation utilising differing methods of calculation.  Banks need to identify risk and exposure for credit or portfolio, liquidity or operational and then allocate capital accordingly.  VaR can be translated to CAR or capital at risk and this measure can give a tolerance level for loss at a given level of risk.  This identified level then can be classed as the default probability of the financial institution.

 

From an industry viewpoint VaR supports the principles of the Basle Committee and sophisticated versions have been developed to support the application throughout the industry.  In Europe the European Parliament and Council of the European Union have laid down directives, know as Capital Adequacy Directives and its descendants, in the recent set or provisions on accurate internal systems for daily risk control and appropriate measures for trading limits.  The regulations require that financial institutions must comply with EU directives.  VaR and its derivatives have the ability to comply.

 

Risk needs to be identified, quantified, mitigated or controlled, VaR and its derivatives is a tool to achieve business measurement and objectives.  However any business and especially the financial sector needs to move forward and create an environment for change management and to strive for better methods of risk management and value creation.

 

Risk is moving up the corporate agenda because of compliance issues, the management of banking risks is a matter of judgment and perspective; different stakeholders in a business see the approach to risk and its management differently.  Risk and its management must be seen as a positive for a financial institution as confidence is all encompassing the downside is failure. Too often though we tend to dwell on the negatives and at times therefore missed opportunities abound.  This is particularly true of banks that as a group at times tend to adopt the lemming principle.  Successful banks of the future will carve out market niches and structures that will facilitate success and enable them to ride the waves of business fortune. 

 

Banks are experimenting with differing structures and one Australian bank and several UK banks have redesigned their structure to manage risk in all its variants under one command structure, this means that many diverse tactical elements of risk are housed under the one administrative umbrella with a clear path to the board via its own senior management.

 

What are the components of business risk that need to be structurally addressed?

 

1. Strategic - the risk of planning failure:Poor marketing strategyPoor acquisition strategyUnexpected changes in consumer behaviourPolitical and regulatory change

 

2. Financial - the risk of financial controls failing:Treasury risksLack of counterparty and credit assessmentFraud and its controlSystemic failurePoor receivables and inventory management

 

3. Operational - risk of human error, either willful or by omissionSystem mistakesUnsafe practicesEmployee routinesWillful destructionFraud

 

4. Commercial - risk of business interruptionLoss of key personnelSupplier failureLegal issues and compliance

 

5. Technical - risk of physical assets failingEquipment failureInfrastructure breakdownFire and physical impactExplosion and/or sabotagePollution Natural events

 

In this scenario financial risk is seen as a component of business risk and not business risk management.  How can the above points be overlaid in such a way as to add value to the financial institution?  We are very well drilled as an industry in the risk and return scenario if we pay attention to the above aspects we can develop another "R", i.e. regret.

 

a. Risk - the level of acceptable exposure in order to create shareholder value.b. Return - the level of shareholder value created in line with the level of risk accepted.

 

A and B above are the traditional measures of value creation and can be graphically illustrated in dollar and percentage terms readily by todays' computer environment.  However C - Regret, is the additional level of analysis required to link business risk analysis with financial risk measurement.

 

c. Regret - the level to which a decision for a given return will be regretted in the future if the worst- case scenario comes to pass.

 

This level of regret can fundamentally change the way in which a financial institution reaches its decision of risk and return and its implemented within the entity.

 

Capital is a scarce resource and the finance community is always looking for smarter ways in which to invest those resources to create greater shareholder value and thus ensure survival and growth.  Banks who fail to develop measures to manage risk will fall by the wayside and be replaced with smarter institutions that can quantify exposure and manage risk for profit that is accept that they are a risk taker and manage accordingly. Regret as a decision tool, along with integrated risk management, consisting of VaR, CAR, liquidity at risk and economic added value in my opinion will over time fundamentally change the approach to the definition of bank management and its need to add value to its share holders.

 

As Kevin Dowd said in his introduction to Beyond Value at Risk - the new science of risk management  "Everything changes and changes can be good or bad for those affected by them.  Change therefore leads to risk, the prospect of gain or loss and risk (or more precisely, the risk of loss) is something that we must all come to terms with.  Coming to terms with risk does not mean eliminating it from our lives, which is clearly impossible; nor does it mean that we should have done nothing about them.  It means that we must manage risk: we must decide what risks to avoid and how we can avoid them; what risks to accept and on what terms to accept them; what new risks to take on and so on."

 

I do not think I have read a better guide to good banking although the author meant it as a general statement.  Most banks tend to punish risk taking from individuals because they at senior management level do not accept the premise that they are in fact risk takers.  A successful bank of the future will be a bank that understands business risk and its customers and can accept a level of risk for an acceptable level of return rather than accepting simply a level of return on any given portfolio.  VaR and its derivatives is potentially an important weapon in a financial institutions armoury of survival.  Banks need to accept the principle of Risk, Return and Regret.  It is the regret factor that will ensure long-term survival.

 

About the Authors

Director
Australasian Risk Management Unit
Faculty of Business and Economics
Monash University

Member Login

Username:

Password:

Validate Member