LONDON, June 8 (Reuters) - Regulators could take a more hands-on approach to supervising the risks individual banks face to avoid relying on flawed in-house computer models that failed to predict losses at JPMorgan, a top Bank of England official said on Friday.
The models are used by banks to set limits on how much risk traders should take on and for calculating how big a bank’s regulatory capital buffer should be.
One of the best known models, Value-at-Risk or VaR, was developed by JPMorgan itself in the 1990s for predicting the likely maximum loss from a portfolio position within a certain “confidence level” - meaning to a reasonable degree of accuracy.
Last month JPMorgan announced losses totalling $2 billion on a portfolio of corporate credit exposures traded at a unit in London. The bank’s VaR model only initially pointed to a loss of $67 million.
Andrew Haldane, Bank of England executive director for financial stability, said in a speech in Edinburgh on Friday that VaR contained a “fatal flaw” by being silent about risks that are beyond normal predictability - known as the tail.
The global Basel Committee on Banking Supervision has already tightened its rules by requiring a stricter version of the model, known as “stressed” VaR from the start of last year.
But the United States, the main supervisor for JPMorgan, has yet to enforce these new Basel 2.5 rules. The Federal Reserve only approved their use on Thursday.
Haldane said some risks were difficult to calculate accurately as some behaviours were unobservable, presenting a serious risk management gap.
No model may be good enough and that means regulators could step in to fill the “risk gap” themselves, signalling a much more interventionist style of supervision to come.
“This gap can most obviously be filled by some systemic oversight agency, able to monitor and potentially model the moving pieces of the financial system,” Haldane said.
He is himself a member of one such agency, the Financial Policy Committee at the Bank of England which, in turn, becomes the main regulator for banks in Britain from 2013.
“One useful role these bodies can play is to provide a guide to the contours of systemic risk - a systemic risk map. This map could provide a basis for risk management planning by individual financial firms,” Haldane said.
Supervisors could be like weather forecasters, providing early risk warnings so that banks can take defensive actions.
“Indeed, the evolution of weather forecasting may provide useful lessons on the directions finance might take - and some grounds for optimism,” he said.
Regulatory moves to account for unpredictable risks - or tails - are also being backed up with “firebreak” approaches such the leverage ratio globally, the Volcker Rule in the United States and the ring-fencing of retail banking arms in Britain, he said.
“Tails should not be unexpected, for they are the rule. It also means putting in place robust fail-safes to stop chaos emerging, the sand pile collapsing, the forest fire spreading. Until then, normal service is unlikely to resume.”