What do the value-at-risk measure and the respective legislative framework really offer to financial stability? Critical views and pro-cyclicality

Evangelos Vasileiou and Themistoclis Pantos
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Evangelos Vasileiou: Department of Financial and Management Engineering, School of Engineering, University of the Aegean, Chios, Greece
Themistoclis Pantos: College of Business, Zayed University, Abu Dhabi, United Arab Emirates

European Journal of Economics and Economic Policies: Intervention, 2020, vol. 17, issue 1, 39-60

Abstract: In this paper, we examine how value at risk (VaR) contributes to the financial market's stability. We apply the Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS of the Committee of European Securities Regulators (CESR 2010) to the main indices of the 12 stock markets of the countries that have used the euro as their official currency since its initial circulation. We show that gaps in the legislative framework give incentives to investment funds to adopt conventional models for the VaR estimation in order to avoid the increased costs that the advanced models involve. For this reason, we apply the commonly used historical simulation VaR (HVaR) model, which is: (i) taught at most finance classes; (ii) widely applied in the financial industry; and (iii) accepted by CESR (2010). The empirical evidence shows the HVaR does not really contribute to financial stability, and the legislative framework does not offer the appropriate guidance. The HVaR model is not representative of the real financial risk, and does not give any signal for trends in the near future. The HVaR is absolutely backward-looking and this increases the stock market's overreaction. The fact that the suggested confidence level in CESR (2010) is set at 99 percent leads to hidden pro-cyclicality. Scholars and researchers should focus on issues such as the abovementioned, otherwise the VaR estimations will become, sooner or later, just a formality, and such conventional statistical measures rarely contribute to financial stability.

Keywords: value at risk; pro-cyclicality; early warning indicators; efficient legislative framework; estimations accuracy (search for similar items in EconPapers)
JEL-codes: G01 G15 G28 G32 (search for similar items in EconPapers)
Date: 2020
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Citations: View citations in EconPapers (1)

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