Monday, 2 June 2008

Right target, wrong ammo

The FT reports:
International regulators and supervisors have started drawing up plans to make it far more expensive for investment banks to hold large volumes of complex financial instruments, such as mortgage-linked securities, in their trading books... though the Basel rules require banks to hold large capital reserves against the risk of credit default in their loan book, regulators only require small buffers for assets held in the trading book if these are labelled as low-risk, according to so-called Value at Risk models.
Up to a point your honour. Certainly there is a well-documented problem with the imprudence of VAR models, especially (but not only) ones which do not capture all the relevant risk factors. But the credit risk rules are not a shining example of prudence either, especially for low PD portfolios.
One need only compare JPMorgan's capital allocation for market risk -- $9.5B at Y/E 2007 -- with its VAR -- $107M -- to see the problem with trading book capital based on VAR alone. But the solution is not to dump on structured products alone: it is to revamp the entire market risk regime.

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