SEC Official Questions Validity of Value-at-Risk; Endorses Mark-to-Market Accounting

The financial crisis revealed limitations in risk valuation metrics such as the widely-used value-at-risk (VaR) model, said SEC Director of Trading and Markets Erik Sirri, in testimony before Senate hearings on risk management. He called for the rigorous stress testing of risk valuation models. But he cautioned that VaR assumes certain historical correlations, which may be inapplicable during times of extreme stress. This model, developed in the early 1990s, was not only accepted as standard across the industry, but adopted by regulators as the basis for calculating trading risk and required capital.

There is a growing consensus of opinion questioning the validity of VaR as a measure of risk. Recently, a UK FSA blueprint for regulatory reform noted that the use of VaR measures based on relatively short periods of time introduced dangerous procyclicality into the assessment of risk. Echoing the SEC director, the FSA said that VaR needs to be buttressed by the application of stress testing that considers the impact of extreme movements beyond those which the model suggests are at all probable. Deciding just how stressed the stress test should be will be inherently difficult, however, and not clearly susceptible to any mathematical determination.

In addition to the deficiency that VaR does not measure liquidity or concentration risk, Mr. Sirri said that a take away lesson from the financial crisis is that, while VaR may be useful during normal market conditions, risk managers and regulators must recognize its imbedded limitations and assumptions and plan accordingly. Specifically, he advised regulators and risk managers to supplement their usage with stress testing that incorporates, not only likely economic scenarios, but also low probability, extreme events. He also emphasized that the market-wide failure to appreciate and measure the risk of mortgage-related assets, including structured credit products, demonstrated that the Basel market risk standard as then in force was not adequate. There is a need for serious improvement of both VaR and the Basel standard.

The importance of proper risk valuation methods is heightened by the fact that these metrics are somewhat connected to the application of mark-to-mark accounting to illiquid securities, as well as other securities. While the SEC knew the importance of focusing on illiquid assets, he said, no regulator truly understood that market perception of the integrity of the financial statements, which involves both the amount of illiquid assets and the valuation of such assets, could erode so precipitously and ignite a run on a securities firm.

In his view, a knowledge of illiquid assets also requires regulators to review valuation thoroughly, and understand how mark-to-market is executed within the firm, with a particular focus on the strength of control processes, the independence of the price verification function, and the disclosures made by the firm on its valuation processes. The crisis teaches that the challenges of valuing illiquid or complex structured products should not cast doubt on the process of marking-to-market, he continued, in fact, the official believes that marking-to-market is part of the solution.

Mark-to-market informs a firm’s senior managers of trading performance and asset price and risk factor volatilities, supports profit and loss processes and hedge performance analyses, facilitates the generation and validation of risk metrics, and enables a controlled environment for risk-taking. Moreover, mark-to-market helps ensure consistency between profit and loss reporting, hedging, and risk measurement. Without it, he said, discipline across these activities would be more difficult to maintain and risk management would be significantly weaker. The act of marking-to-market provides necessary information and can impose discipline on risk-taking and risk management.

At securities firms and elsewhere, he continued, to protect the accuracy and integrity of the financial institution's books and records and to support the CFO's attestation concerning the fair value of the firm's inventory as of a certain date, an independent group of financial controllers verifies monthly that traders' marks are accurate and unbiased. Once the price verification is completed, summary mark review reports are provided to senior managers which provides insight into the composition of the portfolio, as different methods signal different degrees of liquidity, complexity or model risk.