Var crash

Of itself, VAR provides a conservative guide to the huge size of banks' current positions. In simple terms, these models assess the amount of risk that a bank is taking by looking at the volatility of the assets it holds and the correlation between them (the less correlation the better). In that way, banks can see how much they might lose were these bets to sour. Crucially, if markets become less volatile, banks can pile on more positions and still have the same VAR. With the exception of Treasuries, markets have indeed become much less volatile — volatility has halved at least in many markets in the past year-and-a-half. Equity markets are now less volatile than they have been for almost a decade. Roughly speaking, if markets are half as volatile, banks' positions can be twice as large for the same amount of capital. But since VARs have in fact risen, some banks' positions are probably three times what they were in the autumn of 2002.

In fact the situation could be still worse. For banks have been increasing their trading exposures in other ways, too. The most notable is via direct investments in hedge funds, often those set up by traders who used to work for the banks themselves. Chemical Bank, now part of J.P. Morgan Chase, started the trend 15 years ago. Now, almost all big banks invest their own capital in hedge funds.

Citigroup may have shut down its "proprietary" trading operations five years ago (temporarily, it now transpires) but it invested a few hundred million dollars of its money in a hedge fund set up by the traders that ran the bank's proprietary trading. Earlier this month, Deutsche Bank leaked that it was also investing $1 billion in a hedge fund run by its erstwhile traders. J.P. Morgan Chase is thought to be the most generous in doling out its cash, but Credit Suisse, Goldman Sachs, Lehman Brothers, and BNP Paribas together invest hundreds of millions of their shareholders' money in hedge funds.

In total, banks have invested many billions of dollars in such funds. The reason, apart from an understandable desire to invest money with good traders, is that the money that is invested in this way is counted as an investment not as a trading position, and so is not included in the banks' own trading books. Most of the money that banks invest has gone into hedge funds that specialise in bonds and other sorts of fixed-income instruments. Like the banks, hedge funds have been leveraging up their exposures to markets.

This activity is splendidly profitable, as long as markets behave themselves. But the strategy puts banks and hedge funds alike at huge risk if markets suffer a severe shock — a far more common occurrence than banks allow for. Their models (and, yes, hedge funds use VAR models as well) assume a certain level of losses for moves of a given magnitude. The problem comes for the tiny number of crises when markets move much more and, to add insult to injury, banks' assumptions about the diversity of their portfolios are shown to be wrong. In other words, the models, says one regulator with a chuckle, are of least use when they are most needed.

By regulatory fiat, when banks' positions sour they must either stump up more capital or reduce their exposures. Invariably, when markets are panicking, they do the latter. Since everyone else is heading for the exits at the same time, these become crowded, moving prices against those trying to get out, and requiring still more unwinding of positions. It has happened many times before with more or less calamitous consequences.

It could well happen again. There are any number of potential flashpoints: a rout in the dollar, say, or a spike in the oil price, or a big emerging market getting into trouble again. If it does happen, the chain reaction could be particularly devastating this time. Banks and hedge funds have increased their exposures most to those markets that they are least able to withdraw from. Think, if you will, of the extraordinary rise in the price of emerging-market debt and junk bonds. "I used to sleep easy at night with my VAR model," said Mr. Wheat in his speech more than five years ago in Monte Carlo. Suffice to say that he suffered a sleepless night or two when that model was found wanting — and that many a bank boss could be in for the same.

The Economist

Notes

mea culpa — *'my fault" — лат. моя вина, виноват, зд. покаяние, признание вины

value-at-risk (VAR) — «сумма под риском» — одна из моделей, применяемая в управлении рисками

fiat — лат. распоряжение, декрет