I owe you a wee apology and a clarification, but we also have a difference of philosophy.

BT sold a packaged implementation of RAROC. My impression is that the use of RAROC dropped off considerably due to the obvious fact that BT would not longer be there to support the package. Some banks and private vendors stepped into the breech, but I am not clear on how consistent the approaches were post BT

BT also made noise that their approach was not the same as VAR. I had understood there were some differences in the risk metrics, but per your point, they may have been so subtle as to be effectively meaningless.

However, I still beg to differ with you on the regulatory posture, and that may be because I grew up in the securities industry (less heavily regulated than banking) in the early 1980s, when regulators were not afraid to regulate.

I am sure you appreciate how easy it is for organizations to blow themselves up with derivatives. To have taken such a passive approach when these firms have FDIC deposits (in a downside scenario, the public will pay for losses) is inconceivable.

Put another way: it would be OK to keep the industry on a loose leash IF the authorities understood what they were doing. They didn’t and they still don’t. As the FT’s John Dizard pointed out in a FT article, terabytes have been written about how most risk management tools, from Black-Scholes onward, assume a normal risk distribution and therefore fail to make sufficient allowance for tail risks. That is pretty basic, and the idea that the industry pushed VAR isn’t an adequate excuse for ignornace.

With all due respect, I worked in the treasury/risk management area of a large integrated bank/dealer for almost 30 years, and saw the full evolution.

RAROC is a capital attribution system that relied on the same mathematics as Var, which is a risk measurement system. RAROC used Var as a conceptual subset. RAROC superseded Var in scope but certainly did not displace it per se. They were complementary systems, not mutually exclusive. Bankers Trust as you know was the inventor of RAROC. But RAROC did not disappear with the demise of Bankers Trust. It’s had iterations, but is still used, just as Var is.

I agree there were other modes of risk analysis. Traders more or less came to ignore Var except for risk limits. Traders like to develop their own risk measures, like simple measures of interest rate sensitivity, more than the cumbersome macro probabilistic measures inherent in Var. It allows them to do the probabilities intuitively. Var and RAROC were systems for risk managers more than traders.

Var was eventually complemented with scenario analysis, which was supposed to take care of wild market events. The problem is that scenario analysis was a function of imagination among other things, including seeing the next unthinkable risk, such as a general meltdown in credit derivatives or bond insurers. Scenario analysis was a poor substitute for wisdom.

The ‘operational risk’ lay in the degree of marketing of Var by the risk area to the senior executive committees and the Boards, at the expense of more insightful qualitative analysis. This was probably a function of the quantitative DNA in the risk management executive.

Yes, regulators are not up to the task and they can be passive, and are probably underpaid based on the ‘blame put’ that the industry enjoys when the blow ups come along. But they were also sold a bill of goods. Don’t put all the blame there.

Just look at Basel2 – it’s so far behind the curve that it’s in the current environment doing more harm than good.

Coherence (philosophical gambling strategy)
http://en.wikipedia.org/wiki/Coherence_%28philosophical_gambling_strategy%29

In a thought experiment proposed by the Italian probabilist Bruno de Finetti in order to justify Bayesian probability, an array of wagers is coherent precisely if it does not expose the wagerer to certain loss regardless of the outcomes of events on which he is wagering, provided his opponent chooses judiciously.

http://www.military.com/features/0,15240,160195,00.html

Our tax dollars at work, saving the economy, weapon by weapon

This is almost as dangerous as synthetic derivative modeling!

With all due respect, you need to widen your frame of reference. I was working with one of the top derivatives players in the early 1990s, just as the big Wall Street firms were starting to get into the industry.

The Fed, thanks largely to Greenspan’s strong libertarian bias, took a “let a thousand flowers bloom” approach. They let the industry develop its own risk management techniques and just watched (note that the regulators have a legitimate reason to be concerned about risk, since that in term determines how much capital a regulated institution needs to hold).

There was no attempt to intervene in these new products and businesses, and only a limited effort to understand (the math was way beyond the examiners).

VAR was hardly the only approach/system being marketed aggressively in those days (and remember, in those days, the banking industry was even more fragmented than now and the Fed took less interest in Wall Street. That happened in the wake of the LTCM crisis).

The two systems being marketed most aggressively to banks was JPM’s VAR and Bankers Trust’s RAROC (Risk Adjusted Return on Capital). RAROC is a better system for banks, since it gives parameters for product pricing (ie, it was a system that could get everyone on the same page in terms of how to design and price products from the perspective of the bank’s true risk and capital costs). But when BT went down due to reasons unrelated to RAROC, bye bye RAROC,

So the regulators quite deliberately let there be a vacuum as far as risk management of complex new instruments was concerned, and set themselves in a very passive role. Nature abhors a vacuum, and JPM exploited that situation.

But as I said earlier, no firm relies solely on VAR; they use multiple systems. Yet the Fed and OCC are woefully ignorant of those other approaches. It is a regulator’s responsibility to ride herd on its charges. Even if the industry did aggressively market VAR to them, there is no reason for them to have accepted it passively, and to fail to understand the other techniques in use.

Not sure about anyone else but do think that some of these pattern afficianados would make excellent conspiracy theorists or thelogians, not that either profession has much connection apart from “mystical patterns”, gosh, offending too many people today.

Var was developed and aggressively promoted by the industry first, and then sold to the regulators. You paint this as a problem of regulators being biased in their preference for such models. That’s inverted to the actual history.

Many of these new-era mortgages are at the core of the subprime contamination linked to underwriter mis-management which IMHO is related to software based loan applications which often included no-doc loans and various hybridized manipulated variables which resulted in our current pool of chaos.

Furthermore, these new-era mortgages were using rik variables associated with previous generation mortgage trends/history and data that was based on defaults linked to a previous era of greater responsibility, where grandpa and gramma had 30 year conventional loans that were rock solid for 30 years — versus a society of home-flippers that have attention deficit and casino/lotto fever.

The point being, the new era loans did not have ANY default history associated with any verifiable patterns which could be modeled. The models used by rating agencies were based on inappropriate data not relevant to these new loans, thus we have failure rates which were not projected, because they were improperly modeled, because the data used was outdated.

IMHO, this is why the rating agencies and anyone in this housing bubble ignored the reality of unrealistic increases in value and thus risks associated with LTV; it was obvious to anyone that the market was well beyond the froth stage which Greenspan eluded to around 2004/2005. It was insane of these people to not verify more data and to backtest models with cross referenced checks; what are they thinking about? Ill tell you one thing they didnt understand as a collusive group and that is CRT *credit risk transfer)!

Here is interesting link: http://www.ecb.int/pub/pdf/other/riskmeasurementandsystemicrisk200704en.pdf

RISK MEASUREMENT AND SYSTEMIC RISK