[ by Howard Haykin ]

U.S. Banks Should Prepare for "Stressed VaR Tests, Beginning in 2013.

To get a better grasp on the financial conditions of Wall Street firms these days it's not enough to skim the top level of figures offered by the financial statements submitted to the SEC.  It is now necessary to drill down to a level where one can identify the make-up or composition of a firm's investment holdings to recognize so-called complex securities positions and transactions that will enable one to get into more relevant analysis.

That, apparently, is the point at which one may employ something called "value at risk" or "VaR," to see the real picture.

Unmasking the Q3 2012 Season of Financial Reporting. "Value at Risk" is an industry term for one type of stress test that Wall Street banks perform on their assets.  These tests estimate how much money a bank could lose under adverse market conditions.  Value-at-risk tests are hardly fail-safe. For example, they didn't predict the scale of losses that occurred during the financial crisis.  And changes to a value-at-risk model helped cause JPMorgan's multibillion-dollar losses on derivatives earlier this year.

Morgan Stanley said on Thursday that it had changed its value-at-risk model.  Like JPMorgan, it changed the model to comply with new international regulations that American banks must abide by.  The effect of the change was to reduce the estimated amounts that Morgan Stanley could lose in one day in plummeting markets.  Under the new methodology, Morgan Stanley's bond traders might lose $53 million - a big step down from the old model that put the exposure at $76 million.

As tempting as it might be to gloss over and ignore VaR analysis because it comes from a black box and has been unreliable during tough market conditions.  According to Dealbook, that would amount to be a gross error in judgment.

Value-at-risk measurements are crucial in setting capital, which is the financial buffer that banks hold to absorb any potential losses.  Since the financial crisis, regulators have forced banks and other financial institutions to maintain higher capital levels, while also introducing changes to make capital more resilient. 

Banks know they need to hold capital.  Yet, though they prefer to maintain lower capital levels so that they have more funds available for lending or to make bets on.  "The more money that's working the better the chance to take in added interest revenues."   In fact, the objective is to roll over as much money as possible, as many times as possible. 

Value at Risk may provide that opportunity.  Lower loss estimates from value at risk can give a boost to capital ratios, without anything else changing.  Indeed, on Thursday, Morgan Stanley CFO Ruth Porat said that the value-at-risk changes had given a capital ratio a "modest benefit." The new model places more emphasis on market movements toward the end of the four-year period it measures. Right now, that leads to lower loss estimates because it ends up putting less emphasis on the 2008 financial crisis and the two turbulent years that followed.

Morgan Stanley said that its regulators had approved the model changes for use in its capital calculations. Goldman Sachs has yet to give out new value-at-risk loss estimates.

Surprises Lying in Wait - Stressed VaR. This area could yet spring some nasty surprises. Believe it or not, the new regulations actually demand that banks start doing an additional, more stringent value-at-risk test.  Known as stressed V.A.R., European banks have started to report these "stressed" results - and they are far higher than regular value-at-risk readings. In all likelihood, American banks will also have to do this in the first quarter of next year.

In an interview, Ms. Porat said that Morgan Stanley was already using the "stressed" value at risk to help calculate capital requirements. That implies there will be no unpleasant surprises early next year when the stressed approach becomes mandatory. But nothing down the rabbit hole is certain.

For further details, go to:  [Dealbook, 10/18/12].