There’s a lot of finger pointing going around about what led to the current financial market breakdown, but perhaps the most ridiculous target of blame is the very idea of financial derivatives, as if these products sprang out of the ground like a particularly potent crop of poison ivy while no one was looking. In reality, a lot of people were looking, and a fair number of risk managers were warning, but too many institutions were either ignoring or mis-measuring the risk. That’s the conclusion of a new report from Deloitte Center for Banking Solutions.
If the fault lines of the mortgage and asset-backed securities were embedded in their models, so to the failure of risk management was at least partly 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.”