Last orders at the VAR

Inaccurate risk-of-loss estimates threaten to load extra capital charges on US dealers

If a hangover is punishment for a night of heavy drinking, higher capital charges are banks’ penance for running greater risks in their trading portfolios. 

The wild market swings of end-2018 hit dealers’ market risk models like shots of tequila to the stomach. Yet the latest quarterly market risk disclosures suggest the hangover was relatively mild. 

The eight US global systemically important banks (G-Sibs) saw their value-at-risk-based capital charges surge 23% compared with the quarter before. 

This component of the market risk capital requirement tracks each bank’s average daily projected maximum risk of loss, estimated using VAR models. As such, it reflects banks’ own guesses of the amount of capital needed to absorb trading losses.

But much like the optimistic imbiber underestimating their alcohol tolerance, banks’ VAR models can underestimate their maximum daily risk of loss. When actual losses exceed modelled estimates, a VAR breach is the result. These are red flags to regulators. Frequent breaches imply a bank’s VAR model is not fit for purpose. The VAR-based capital charge is calculated by multiplying a bank’s projected average daily loss estimate by three. But if a bank sees more than four VAR breaches over a rolling 250-day period, the multiplier climbs in increments to a maximum of four with every additional breach. 

Much like the optimistic imbiber underestimating their alcohol tolerance, banks’ VAR models can underestimate their maximum daily risk of loss. When actual losses exceed modelled estimates, a VAR breach is the result

After a rocky fourth quarter, some banks are facing the prospect of multiplier increases. State Street has seen four VAR breaches over the past 250 trading days. The US unit of Credit Suisse is in the same position. Bank of America has three breaches. BNP Paribas is already over the limit with eight, and is subject to a 3.75 multiplier. That should dissuade these banks from lowballing their loss estimates in the months ahead. 

Still, the consequences of frequent VAR breaches should not be overstated. The US market risk requirements include five other components, which act as an extra layer of protection. The stressed VAR charge, for example, forces dealers to hold enough capital to cover expected maximum losses in a period of severe market tumult. The specific risk add-on and de minimis positions add-on capture risks that may not be fully covered in a bank’s VAR model.

The VAR-based capital charge accounts for less than 10% of US G-Sibs market risk capital charges. So, models and standardised formulas used to capture other aspects of market risk are of much greater importance. But the threat of multiplier increases may prompt banks to be more conservative with their VAR estimates in future.