research@hec - Issue#2 - (Page III)

Based on an interview with Christophe Pérignon and on his articles “Do Banks Overstate their Valueat-Risk?1" (Journal of Banking & Finance, 2008) and “The Level and Quality of Value-at-Risk Disclosure by Commercial Banks2” (presented at the 2008 Conference of the American Finance Association). Measuring Market Risks in Banks With the increase in incidents of colossal losses suffered by certain banks, a need has grown since the 1990s for greater transparency in the banking world. Daily risk assessment was seen as a vital initiative to support the banks’ trading positions. And yet, ten years on, while risk is now a core concept in the financial system, Christophe Pérignon has observed that little has been done to analyze the quality of risk measurement systems. He decided to correct this situation and, in 2005, carried out a detailed analysis of data drawn from the risk management systems of numerous banks around the globe. Can banks measure precisely the market risks that influence their position? Not necessarily, according to Christophe Pérignon, whose empirical studies into the matter point to a general tendency for banks to overstate the risks when the markets are stable and to underestimate them in periods of financial crisis. M WHY MEASURE MARKET RISKS? Since the amendment of the Basel Accord of 1996, financial authorities require the banks to put aside sufficient capital reserves to guard against both financial and market risks. Each bank needs to be able to assess the risks it faces on a daily basis. While the regulator imposes no specific risk assessment models, the banks must show that the models they use are reliable. This way, the market risk assessment systems used by the banks satisfy the financial regulator’s monitoring requirements. Moreover, in a highly competitive business environment, any bank that can measure the risks it faces gains a competitive edge, while demonstrating the dependability of the models it uses. ARE THERE ANY IDEAL EVALUATION TOOLS? Value at Risk (VaR) is currently the best system for measuring market risk. It refers to the maximum loss with a given confidence level (generally at 99%) in a set period of time (for example, in one day). Ideally, this model is designed to avoid exceptions, meaning days when the actual losses are superior to the estimated losses. From a more operational point of view, VaR is used when communicating to traders the maximum positions they are authorized to take. It’s the standard market risk measurement tool. DOES THE RISK ESTIMATED BY BANKS CORRESPOND WITH ACTUAL RISK? One of our studies involved examining six major Canadian banks between 1999 and 2005—representing a total of 7,354 trading days—with the intention of comparing their risk estimation and actual risk. We observed, in total, that of the 74 forecast exceptions (1% of 7,354), actual losses only exceeded estimated loss in two instances. This surprising result was backed up by the observations we gathered from studies carried out on other banks around the world (including the Bank of America, Deutsche Bank, and Société Générale) as they confirmed the banks’ tendency to overstate the risks they face. Paradoxically, most CAREER Christophe Pérignon is an Associate Professor of Finance at HEC and holds a PhD in Finance from the Swiss Finance Institute (Geneva). Prior to joining HEC, he was Assistant Professor at the Simon Fraser University in Vancouver, Canada, and a PostDoctoral Fellow at the University of California in Los Angeles (UCLA). At HEC he teaches Derivatives in the Finance Major of the MSc program and Financial Markets in the MBA program. His areas of research are asset pricing and risk management. April-May 2008 • research@hec III http://www.hec.edu/hec/eng/professeurs_recherche/p_liste/p_fiche.php?num=174

Table of Contents for the Digital Edition of research@hec - Issue#2

Cover & Contents
Research Committee: Corporate Involvement in Research Projects
Measuring Market Risks in Banks, by Christophe Pérignon
Being Successful as an Expat in Japan, by Vesa Peltokorpi
Goodwill, Accounting, and Governance, by Hervé Stolowy

research@hec - Issue#2