Better Understanding VaR on the Road to FRTB
17th-century mathematician Blaise Pascal, as one of the early statistical risk pioneers, not only measured risk but began differentiating between its weightings and resulting consequences. For example, if an apple fell on your head, not terrible, but if it was a blacksmith’s anvil, then of much greater consequence.
And in the financial world, a heavy loss of capital is of extreme high risk and consequence. Value at Risk (VaR) has become the de facto modeling tool for managing enterprise market risk. VaR has been utilized in finance for decades but really became the mainstream model standard post the 1987 financial crash. At that point it was accepted that a high-water mark confidence level, usually 95/99%, was a loss value that could be accepted.
Well, not exactly. The 2007-08 financial crisis exposed the VaR high-water barrier as being breached and vulnerable in managing a crest of financial contagion. The first major item addressed was to clearly separate the banking book from the trading book. The Interest Rate Risk in the Banking Book (IRRBB) measure has addressed the banking book. Now on the capital markets side of banking, the Fundamental Review of the Trading Book (FRTB) is tackling the trading book.
The separation of the banking and trading book was implemented with the primary goal of attempting to manage fat tail events, basically raising the high-water mark. Furthermore, VaR modeling has extended with Expected Shortfall. Rather than using a single high-water mark for a VaR-specific distribution confidence level, this modeling takes in and scrutinizes the full tail. This then raises the loss variable to the expected mean of the tail versus the past single point.
As you can see, measuring risk and the potential consequences is multifaceted and dynamic. FRTB quickly becomes complex when non-modellable risk factors (NMRF) and P&L attribution come into play. The financial world continues to learn from the past while attempting to plan safely for the future. For valuable VaR modeling insight and the FRTB journey ahead, check out Finastra’s Treasury and Capital Markets: Pricing and Risk Metrics Understanding Value-at-Risk (VaR).