Today's economic mess has led to plenty of finger pointing, but the failure of risk management models is surely a prime culprit. As it turns out, however, a fair number of risk managers were warning about the stability of financial derivatives, according to a new report from the Deloitte Center for Banking Solutions. Unfortunately, the report also says too many institutions either ignored them or mis-measured the risk.
The failure of risk management was rooted in overdependence in value-at-risk models, or VaRs. "Partially as a result of the Basel Market Risk Amendment [in 1996], major global banks widely adopted VaR in the mid-to-late 1990s, and it became the industry standard approach for measuring risk," according to Deloitte. This turned out to be a flawed approach. For one thing, VaR "is not a predictive tool-it cannot foretell catastrophe from so-called stress or tail events, as it is usually based on historical data, which creates an overly sanguine picture in prolonged boom periods."