Value at risk and lessons learned

Value at Risk (VaR) estimates potential loss on mark-to-market portfolios, over a stated time horizon with a specific low probability of being exceeded. Probability of loss greater than VaR is usually 1% (99% confidence level) or 2.5% (97.5%). Widespread adoption of VaR as an industry standard was strongly driven by regulation. The Global Financial Crisis (GFC) exposed weaknesses in the 1996 Internal Models Approach (IMA) of the Basel Committee on Banking Supervision (BCBS). Due to cost and complexity of IMA relating to Fundamental Review of the Trading Book (FRTB), and doubts about capital benefits, only a few major banks will use IMA. Most will use Standardised Approach (SA). This potentially ushers in a new era for VaR, giving SA banks freedom to tailor VaR to their businesses, not using regulatory VaR. This paper identifies VaR characteristics, illustrating false security of VaR calculations, along with observations of refined VaR going forward.