Must have more than one View of Risk
Riskviews finds the headline Value-at-Risk model masked JP Morgan $2 bln loss to be totally appalling. JP Morgan is of course famous for having been one of the first large banks to use VaR for daily risk assessment.
During the late 1980’s, JP Morgan developed a firm-wide VaR system. This modeled several hundred risk factors. A covariance matrix was updated quarterly from historical data. Each day, trading units would report by e-mail their positions’ deltas with respect to each of the risk factors. These were aggregated to express the combined portfolio’s value as a linear polynomial of the risk factors. From this, the standard deviation of portfolio value was calculated. Various VaR metrics were employed. One of these was one-day 95% USD VaR, which was calculated using an assumption that the portfolio’s value was normally distributed.
With this VaR measure, JP Morgan replaced a cumbersome system of notional market risk limits with a simple system of VaR limits. Starting in 1990, VaR numbers were combined with P&L’s in a report for each day’s 4:15 PM Treasury meeting in New York. Those reports, with comments from the Treasury group, were forwarded to Chairman
Weatherstone. from History of Value-at-Risk:1922-1998 by Glyn Holten
JP Morgan went on to spin off a group, Riskmetrics, who sold the capability to do VaR calculations to all comers.
Riskviews had always assumed that JP Morgan had felt safe selling the VaR technology because they had moved on to something better.
But the story given about the $2 billion loss suggests that they were flubbing the measurement of their exposure because of a new risk measurement system.
Riskviews would suggest two ideas to JP Morgan:
- A firm that makes its money taking risks should never rely upon a single measure of risk. See Risk and Light and the CARE Report for further information.
- The folks responsible for risk evaluation need to apply some serious standards for their work. Take a look at the first attempt of the actuarial profession of standards for professionals performing risk evaluation in ERM programs. This proposed standard suggests many things, but the most important idea is that a professional who is evaluating risk should look at three things: the risk taking capacity of the firm, the risk environment and the risk management program of the firm.
These are fundamental principles of risk management. Not the only ones, but principles that speak to the problem that JP Morgan claims to have.