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Drastic Times Call For Drastic Risk Measures: Why Value-at-risk Is (Still) a Flawed Preventative of Financial Crises and What Regulators Can Do About It | Author: Andrew L. McElroy

Drastic Times Call For Drastic Risk Measures: Why Value-at-risk Is (Still) a Flawed Preventative of Financial Crises and What Regulators Can Do About It | Author: Andrew L. McElroy

Bank regulators recently proposed the most fundamental reforms to U.S. banking law in decades, yet the value-at-risk statistic—replete with known deficiencies—remains the basis of the capital adequacy requirement. Consequently, there exists an unresolved tension in the law: the purpose of the banking rules is to require riskier financial institutions to hold additional capital, yet the value-at-risk statistic used to make this assessment induces a perverse incentive to hold the riskiest securities. Overlaid on this framework is the wide latitude afforded to banks in designing their value-at-risk models.

This Article explores foreseeable issues with the regulatory reliance on value-at-risk. Moreover, it details specific problems associated with the design and implementation of this risk measure in the context of the capital adequacy requirement. The analysis draws on empirical data and uses advanced econometrics to engage these issues with the sophistication used at financial institutions. The Article introduces a supplemental risk measure that may mitigate the incentive for banks to hold the riskiest securities, and may allow regulators to introduce a system of capital surcharges accordingly.

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