A good analysis by Simon Johnson at Baseline Strategy, on why VaR (Value at Risk), a measure that was supposed to model risk but proved worthless, was preferred to more common-sense approaches:

“Given that everyone is agreeing sophisticated risk models are worthless in crises, it seems particularly remarkable that regulators allowed some banks to use their in-house models in determining their own capital requirements – since one of the purposes of capital requirements is precisely to provide a cushion that protects banks (and their creditors, and taxpayers) in the event of a crisis. The obvious solution is that regulators should rely on cruder constraints, such as an absolute limit on leverage that banks cannot arbitrage around (one of the recommendations of Treasury’s recent white paper on capital requirements, which we discussed here), or periodic stress tests that estimate how bank asset portfolios will perform in a real crisis.

But there is a more interesting question to ask as well: why did VaR become so popular? It’s important to remember that competition among models is shaped by the human beings who create and use them, and those human beings have their own incentives.

David Colander made this point about economic models: the sociology of the economics profession gave preference to elegant mathematical models that could describe the world using the smallest number of parameters. “Common sense does not advance one very far within the economics profession,” he says.

A similar point can be made about VaR models. Sure, maybe all the financial professionals who design and work with VaR know about its shortcomings, both mathematical and practical. But nevertheless, using VaR brought concrete benefits to specific actors in the banking world. If common sense would lead a risk manager to crack down on a trader taking large, risky bets, then the trader is better off if the risk manager uses VaR instead.

Not only that, but imagine the situation of the chief risk manager of a bank in, say, 2004. As Andrew Lo has argued, if he attempted to reduce his bank’s exposure to structured securities such as CDOs, he would be out of a job; VaR gave him a handy tool to rationalize a situation that defied common sense but that made his bosses only too happy. And at the top levels, CEOs and directors who probably did not understand the shortcomings of VaR were biased in its favor because it told them a story they wanted to hear.“

My Comment:

Of course, that is precisely the theme of “Mobs, Messiahs, and Markets.” The banking industry (and the real estate industry and the regulators and the buyers) were fooled, because – to a greater or lesser degree – most of them wanted to be fooled. Their own self-interest found it useful.

Mundus vult decipi. The world wants to be deceived.

Johnson being ex of the IMF (now housing the new global regulatory regime) is drawing the conclusion from this that you need to have tougher regulations. That leaves unsaid the “who will regulate the regulators” part of the equation. And even more importantly, it ignores the more fundamental problem of what drove this kind of speculative behavior, in the first place. The real problem is cheap money, not regulations, per se. Which takes you back to the Federal Reserve, rather than to the regulators or the banking industry.….. which goes back to fractional banking and the globalist cabal….which goes back to the whole world government project….which goes back to…well, you tell me, where that goes back to.

But you’ll never hear that from anyone in the MSM.