What Does Goldman’s VaR Mean?

Goldman Sach’s recent record profit announcement has been much in the news lately.  See Chart 1 at right (image source CNN).  And in some quarters at least, so has its Value-At-Risk (or VaR), which has also steadily increased.  See Chart 2 below (source Felix Salmon).

VaR, a measure of the maximum possible loss of a portfolio over a given period of time at a specified confidence level, has suffered from a PR problem of late.  In brief, as the financial crisis has unfolded, antagonism to VaR and other statistical methods for modeling market risk exposures has intensified in some quarters. Whereas critics argue that VaR’s focus on more probable, quantifiable events causes some institutions to ignore the more improbable events that sparked the current financial crisis and other well- known risk management mishaps, VaR defenders contend that the fault lies not with mathematical models, but with human error.  (For more detail on VaR and the debate surrounding its use for various purposes see here generally, and especially at pp. 149-150). 

Goldman’s increased VaR measures naturally have prompted debate about whether the firm’s profits have been garnered through excessive risk-taking, putting the financial system (and taxpayer dollars) at risk.  Pablo Triana argues in Business Week, however, that:

Whatever your opinion of Goldman's fortunes and market forays in this recession, the fact is that a VaR-based analysis of any firm's riskiness is useless. VaR lies. Big time. As a predictor of risk, it's an impostor. It should be consigned to the dustbin. Firms should stop reporting it. Analysts and regulators should stop using it. (HT: Paul Kedrosky)

As I argue here, whatever the shortcomings of VaR as a measure of institutional market risk, the possibility for error and overreliance on statistical models are much greater in the context of operational risk. Although the issue of operational risk regulation has (understandably) taken a backseat to other more pressing regulatory concerns of late, the Basel II capital accord requires banks to include in their capital charges amounts sufficient to protect against anticipated operational losses, including losses from unauthorized trades, transforming what was once a residual risk category into a growing multi-billion dollar risk management industry.  I conclude that the Basel II OpRisk provisions are unlikely to substantially alter financial institutions’ ability to successfully manage operational risk, and also pose the danger of high costs, a false sense of security, and perverse incentives.

For more on operational risk and the Basel provisions see (pictured at right) Operational Risk Toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation (Greg N. Gregoriou, ed., Wiley 2009). The book consists of chapters by professors (including me), practitioners, and consultants in the area of OpRisk.

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