How risky do you want your bank investments to be? Don’t laugh, it is a serious question.

July 1, 2013, 5:41 p.m. ET

Tracking Risk Isn’t So Easy

FRANCESCO GUERRERA

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How risky do you want your bank investments to be? Don’t laugh, it is a serious question. These days, investors can adopt a buffet-style approach to bank risk. To get a sense of what is on offer, take a look at the table accompanying this column. It is an attempt by Fitch Ratings to get an apples-to-apples comparison of banks’ “value-at-risk,” or VAR, the most common yardstick of trading risk. VAR is designed to measure the maximum trading losses faced by a bank in a single day.So if you fancy a bank that takes big bets on equities, Goldman Sachs Group Inc.GS +0.33% was the one for you in the first quarter, according to Fitch. Want a Wall Street firm that swings big on commodities? Look no further than Morgan Stanley MS +0.65% . If foreign exchange is more your thing, do consider Citigroup Inc.C +0.58% But if it is interest-rate and credit risk you crave, Bank of America Corp.BAC +0.54% could be an ideal choice.

Risk is inherent in any investment, and a high VAR needn’t be, in itself, a bad thing. It actually could signal that a bank is a better trader than its rivals. But the issue for investors, regulators and bank executives is whether they can properly monitor the risks large institutions take in the markets.

This isn’t an academic exercise for risk nerds. The inability to assess, and price, trading risks was a significant factor behind the huge losses sustained by banks during the financial crisis. As monetary and economic uncertainties push markets into a new period of turbulence, is the system better prepared?

It doesn’t look that way. There are two fundamental deficiencies in the way banks report their stance on risk: transparency and consistency. The result is that it is nearly impossible for an outside observer, be it an investor or a regulator, to compare trading risks across banks.

Even regulators admit it. When the Basel Committee on Banking Supervision, the international group of watchdogs in charge of designing new capital standards, looked at the issue recently, it concluded that, “in generalpublic disclosures did not provide sufficiently granular information to establish conclusively what is driving the differences” among banks’ assessments of risk and capital.

Banks didn’t want to comment publicly on the Fitch report. In private, though, many sniped at the firm’s findings, saying that it was crude and imprecise to try to harmonize their VARs.

That is precisely the problem. Banks, with the backing of regulators, are allowed to report VAR in inconsistent ways. Some compare the latest quarter’s risk with the previous two years of trading, and some take in five years—an important difference given the 2008 financial crisis. Some look at the potential maximum losses over one day with a 95% probability of being right, others over 10 days with a 99% probability. Some report VAR each quarter and some once a year. Some even change their VAR depending on which regulatory form they are filing.

A bank’s chief risk officer summarized the warring VARs thusly: “It’s like weighing yourself and announcing your weight in pounds and kilos. But it’s even worse than that; it’s like pounds on the moon and kilos at the bottom of the ocean.”

To make matters worse, VAR is a partial measure. For a start, it varies depending on the methodology. In 2012, for example, J.P. Morgan Chase JPM -0.57% implemented a different VAR that had the effect of playing down the bets taken by the traders at the center of the “London whale” scandal.

Second, it offers only a glimpse of a bank’s overall risk. In July 2008, investors in Lehman Brothers Holdings Inc. would have been reassured to see VAR substantially lower from both the previous quarter and the previous year. Two months later, the firm was gone.

As Wilson Ervin, a risk expert who is a vice chairman at Credit Suisse Group AG,CSGN.VX +3.51% puts it, “VAR is like a car’s speedometer. You wouldn’t want to drive without it. On the other hand, if you just looked at the speedometer and didn’t look through the windscreen you wouldn’t have that good an afternoon.”

Unfortunately, investors and regulators don’t have the same dashboard of indicators as executives and are forced to drive blind.

Some regulators, such as the Basel Committee, and industry groups such as the Global Association of Risk Professionals are slowly trying to remedy the situation. They are testing common ways of measuring risks that look at the same, hypothetical, basket of securities and assess their risks in different market conditions. But the concern with such portfolios is that they could mask the real state of a bank’s risks and be open to manipulation.

As markets get choppy, investors should make sure they don’t choke on the risk buffet being laid out by financial groups.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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