Frederick Sheehan will speak at
the Committee for Monetary Research and Education (CMRE) dinner on Thursday,
May 17, 2012. It will be held at The Union League Club in New York. He will
discuss "How We Got Here."
After the financial crisis in 2008,
"Too-Big-To-Fail" banks had to go. In 2006, the four largest banks -
J.P. Morgan Chase, Bank of America, Citigroup, and Wells Fargo - held 33% of
U.S. bank assets. Now, they hold 41% of U.S. bank assets and grow by the
minute.
The Federal Reserve is, at least on paper, the
country's leading bank regulator. Instead, it behaves like the TBTF banks'
turbocharger. Federal Reserve Chairman Ben S. Bernanke is full of talk, and
nothing else:
"First, is that 'viewed too big to fail' is a very, very
serious problem, and one that was much bigger than expected. And I think that
if there is only one thing we do in financial reform, it is to get rid of that
problem."
-Federal Reserve Chairman Ben S. Bernanke, November 17, 2009,
testifying before the Financial Crisis Inquiry Commission.
A cause of the 2008 financial crisis was the failure of bank-risk models. Those
who understood the Value at Risk model (VaR: the standard) knew it would fail.
It is designed to fail in a financial crisis. The same model failed at
Long-Term Capital Management and Enron. Yet, the Value at Risk model is still
the primary model used to limit risk at financial institutions.
A financial crisis develops once in a blue moon.
Therefore, there is less than a one percent chance of a meltdown, as defined by
the model. The VaR model captures 95% (or 99%) of possible scenarios, as
defined by banks and, supposedly, in conjunction with regulators and rating
agencies. ("House prices never go down nationally.") J.P. Morgan
invests within the 99% of scenarios as modeled by VaR.
If the VaR model were to include that one percent
("tail risk," in the argot) in its measurement of likely losses, J.P.
Morgan would only hold Treasury bills. That assumes J.P. Morgan thinks the
risk-free rate is defined by Treasuries. The Bank of Bernanke is doing its all
to terminate this academic benchmark.
Ben Bernanke did not discuss VaR models
before the Financial Crisis Inquiry Commission in 2009. He is a vague sort of
fellow, so et cetera-ed himself from the burden of learning anything about
banking before his appearance:
"To
avoid another financial crisis, we need to identify "the macroeconomic
context, evolution in the types of businesses, and their risk management, et
cetera."
-Federal Reserve Chairman Ben S. Bernanke, November 17, 2009,
testifying before the Financial Crisis Inquiry Commission.
On the very same day when J.P. Morgan
Chairman Jamie Dimon announced his bank had lost a few billion dollars due to a
haywire VaR model, Simple Ben told a congregation of central banking
enthusiasts in Chicago what a swell job he is doing as the United States'
leading bank regulator. The speech is a piñata of false claims poised to scatter
around the global village. The final blow could strike at any time. Possibly,
at a bank with a $71 trillion derivative book (i.e., J.P. Morgan):
"A number of key systemic risk measures that evaluate
the potential performance of firms during times of financial market stress have
improved in recent months. These indicators of systemic risk are now well below
their levels in the crisis, and, overall, they present a picture of a banking
system that has become healthier and more resilient. ....Such measures
include the conditional value at risk, or CoVaR, which is an estimate of the
extent to which a bank's distress would be associated with an increase in the
downside risk to the financial system."
-Federal
Reserve Chairman Ben S. Bernanke, "Banks and Bank Lending: The State of
Play," conference on Bank Structure and Competition, Chicago, Illinois,
May 10, 2012
The Fed chairman probably thought
he would impress the audience when one of his footmen wrote"CoVaR"
rather than "VaR" in his speech. At least, Investopedia.com does not
rate CoVaR any better than VaR at controlling that good-for-nothing tail risk:
CoVaR:
Conditional Value at Risk was
created to be an extension of Value at Risk (VaR). The VaR model
does allow managers to limit the likelihood of incurring losses
caused by certain types of risk - but not all risks. The problem with
relying solely on the VaR model is that the scope of
risk assessed is limited, since the tail end of the distribution of loss
is not typically assessed. Therefore, if losses are incurred, the amount
of the losses will be substantial in value.
Possibly reading more into the story below than is true, it appears J.P. Morgan
announced it was junking CoVaR, and readopting its plain, old VaR model, at the
moment (one hopes) Ben S. Bernanke was extolling CoVaR's qualities in Chicago:
Front-page
headline story in the following day's Wall Street Journal, May 11, 2012:
J.P.
MORGAN'S $2 BILLION BLUNDER: BANK ADMITS LOSSES ON MASSIVE TRADING BET GONE
WRONG; DIMON'S MEA CULPA
"Fears
Deepen Over Risk Model" Financial Times, May 14 2012:
"It is one more failing in the history of shortcomings
for the model. Last week, JP Morgan Chase revealed a major defect in one of its
key risk management tools. Instead of helping to predict the surprise $2
billion trading loss announced by the bank, Value-at-Risk had helped disguise
the riskiness of JP Morgan's portfolio."
"Trading Desks Face Tighter Regulations," Financial
Times, May 14, 2012:
J.P. Morgan "said it was reverting to an older version
of its VAR metric after having switched to a new model earlier in the
year."
From the same story: "'How can a hedging strategy turn
into a huge trading loss? It doesn't make any sense,' the regulator said."
This is not going to end well.
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