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Morgan Stanley shows the ‘flaky’ side of model

19 October, 2012

 Morgan Stanley has reignited a debate over how investment banks measure daily trading risks after it adjusted its own benchmark of potential losses in a move that boosted its reported capital buffers.

The bank said that it had changed its so-called “value at risk”, or VaR, model as it announced third-quarter results on Thursday.

The VaR models played a key role in the run-up to the recent financial crisis. The models attempt to gauge how much money a bank is likely to make or lose from trading, but were criticised for failing to anticipate big movements in markets.

They have come under renewed scrutiny in the wake of JPMorgan’s $7bn trading loss. The bank changed its VaR model multiple times before and after it discovered the massive derivatives trades undertaken by its so-called “London whale”.

Under new rules, banks are prohibited from trading for their own books but they still assume trading risk on behalf of their clients.

Morgan Stanley’ change reduced its average VaR in the third quarter to $63m instead of the $82m it would have been under the company’s old model. That means under the new model the bank expects to lose no more than $63m in a single trading day, within a certain probability, rather than $82m under the old model.

“It all goes to point out, again and again and again, how malleable and manipulable and flaky VaR can be,” said Pablo Triana, professor at ESADE Business School. “Just change weights on data and, voila, you are perceived as less risky and you can be more leveraged.”

Ruth Porat, Morgan Stanley’s chief financial officer, said that the bank had changed the VaR model to be more heavily weighted to one-year historical data. The model was previously geared towards four-year data.

“We’ve been running this model and the prior model in parallel since 2011, which gives us a high level of comfort from the model,” Ms Porat told analysts Thursday. “It’s been approved by regulators.”

“VaR is just one of multiple measures of risk we use to assess overall risk in the organisation,” she told analysts.

Even so, the change in the model gave a “modest benefit” to the bank’s regulatory capital ratios in the quarter, Ms Porat said. The lender’s capital ratio under Basel III rules rose to more than 9 per cent, helped by earnings and the bank’s efforts to offload assets that attract higher risk-capital weightings.

Morgan Stanley said the new model was needed to comply with “Basel 2.5” regulatory capital rules, which require different risk measure requirements.

While the bank swung to a loss in the third quarter because of a large accounting adjustment, underlying revenues were stronger than in the previous quarter and adjusted earnings of 28 cents a share beat analysts’ estimates of 25 cents a share.

Nonetheless, analysts and market observers were keen to dissect the bank’s VaR shift.

“You can appreciate the idea of changing a VaR model; it gets people’s attention these days,” Mike Mayo, a bank analyst at CLSA said on Thursday’s conference call.

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Morgan Stanley shows the ‘flaky’ side of model

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