Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition

Preface

This is a story of the illusion of risk measurement. Financial risk management is in a state of confusion. The 2008 credit crisis has wreaked havoc on the Basel pillars of supervision by highlighting all the cracks in the current regulatory framework that had allowed the credit crisis to fester, and ultimately leading to the greatest crisis since the Great Depression. Policy responses were swift—UK’s Financial Services Authority (FSA) published the Turner Review, which calls for a revamp of many aspects of banking regulation, and the Bank of International Settlements (BIS) speedily passed a Revision to its Basel II, while the Obama administration called for a reregulation of the financial industry reversing the Greenspan legacy of deregulation. These initiatives eventually evolved into the Basel III framework and Dodd-Frank Act respectively.

The value-at-risk risk measure, VaR, a central ideology for risk management, was found to be wholly inadequate during the crisis. Critically, this riskometer is used as the basis for regulatory capital—the safety buffer money set aside by banks to protect against financial calamities. The foundation of risk measurement is now questionable.

The first half of this book develops the VaR riskometer with emphasis on its traditionally known weaknesses, and talks about current advances in risk research. The underlying theme throughout the book is that VaR is a faulty device during turbulent times, and by its mathematical sophistication it ...