VaR and Stress Tests - Financial Markets by Yale University #4 - YouTube

And I just mentioned, there's something else in finance called VAR.

Actually, I have on the slide that it means two things.

It means variance and it means value at risk but actually there's

a third one that's vector autoregression but I don't...

I was just thinking that it can be confusing.

So the variance of a portfolio is defined as a measure of it's variability.

In finance, some people use VAR for 'value at risk' and this term is relatively new.

It didn't appear until after the stock market crash of 1987.

And so, it's a measure used by some finance people to quantify risk

of of an investment or of a portfolio and it's

quoted in units of dollars for a given probability and time horizon.

For example, if it says lets's say 1%,

one-year value at risk of 10 million,

it means that there is a 1% chance that the portfolio will lose 10 million in one year.

And then, there's another measure of risk that's

become popular in recent years especially after

the financial crisis of 2007-09 and that's called the stress test.

Now, the term stress test goes back to

the 1960s or so and it refers to something that your doctor would

order if he was worried about your heart and he would

have you get on a treadmill in a medical facility,

and run and they have an electrocardiogram hooked

up to you and they check out your heart while you're under stress,

the stress of running.

But now the term has moved into finance.

Office of Federal Housing Enterprise Oversight actually was

doing stress tests on Fannie Mae and Freddie Mac before the 2008 crisis.

It didn't work. Those two firms both failed but they were trying anyway.

So, a stress test reflects the idea.

It's not a basic statistical concept, it's a measure.

It's a method of assessing risks to firms or portfolios.

The idea of a stress test is that,

let's look at a portfolio not just by its historical returns and how variable they are,

but let's look at the details of the portfolio and ask what vulnerabilities there are for

various kinds of financial crisis because what

actually stresses firms the most are crisis,

it's not just normal variation and this is something I'm going to come back to later in

this lecture that there are extreme events occur and so...

The stress test is a test usually ordered by

government to see how some firm will stand up to a financial crisis.

The Dodd-Frank Act in the United States of 2010 requires the Federal Reserve

to do annual stress tests for non-bank financial institutions it supervises.

I think they're already doing them for banks and they wanted to be

at least three different economic scenarios that the Fed would present.

What they would do is, they would get information from

the firm about all of their interconnectedness with other institutions,

everything they own, how safe is it,

and they would look at, say for example,

what would happen if there were a severe recession,

or what would happen if the dollar depreciated or appreciated,

or what would happen if there's a short term liquidity crisis with

suddenly ability to borrow money in the short term dries up.

The Dodd-Frank Wall Street Reform and Consumer

Protection Act was passed into Federal law on July 21,

2010 as a response to the financial crisis of 2007 to 2008.

This Act constitutes the most significant changes to U.S. financial

regulation since the regulatory reform that followed the Great Depression.

The Dodd-Frank Act didn't specify what the three different scenarios were,

but they did say that there should be at least three.

So this is a different story.

This is scenario analysis.

It's not something that we're going to emphasize in this course because

it's... More institutional details that get into the calculations.

The European banking authority which was created in 2011,

after the financial crisis,

has also instituted regular stress tests for European banks.

The United Kingdom, China and other countries all do

stress tests now but the question is, do they work?

Well, there is a growing amount of

skepticism that they can really measure what will happen in the next crisis.

Anat Admati is a professor at Stanford who's been arguing it's all garbage. You can't.

These guys who are trying to predict what will happen to

these companies in a financial crisis,

they just don't have the imagination and understanding of how things work out in a panic,

in a financial panic and she thinks that they are just way underestimated.

Generally, the stress test come out saying it's okay, don't worry.

It does remind me, I was on stage with the chief economist of,

Freddie Mac here at Yale.

We had a... It was around 2005 and he was boasting about their stress tests.

And he said that...

So I asked him what if there's a real estate crisis and home prices fall a lot.

They're company that guarantees mortgages on homes,

and so he said, "Well,

we have figured out what would happen to

our portfolio even under extreme stress situations."

I said, "Well, what is your...? ". I did this on

stage not this stage, it wasn't build yet.

I said, "What's the biggest price decrease you ever considered for your stress test?"

They said, "Oh, we considered a 13% drop in home prices."

And then I said to him, "Well,

what if it's bigger than that?"

And then he looked chagrined then he said,

"We've never seen home price drops,

not since the Great Depression.

You're not talking about another depression,

are you?". We're still friends.

I still meet him on vacation but the problem is that home prices fell

30% right after that meeting or within a couple of years.

And these two companies,

Fannie and Freddie that were considered safe.

Well, actually if you read the OFHEO reports on the stress tests back,

and they will say, there is some concern still.

You know, they're hedging,

but basically they said don't worry and so that was the end of OFHEO.

The government shut it down.

So the question is whether we can do it this time.

So Anat Admati doubts that we can do this time.

She thinks there are bigger worries.

The stress tests are all coming out as no problem but now she's not so sure.

If I were the CEO of a firm,

I imagine I would ask for

stress tests and doing it internally, but you don't want it public.

What if it comes out bad?

See, the problem is if you ever release

that information then all of your other companies that might do

business with you are worried about

that and so they wouldn't want to do business with you.

So, it's like your reputation is at stake.

So if the government demands that you reveal information for a stress test,

you have every incentive that you try to whitewash it.

And so the question is whether the regulators have enough incentive to demand and push.

The Dodd-Frank Act gave regulators,

the Office of Financial Research subpoena power,

so they can go in there and demand information from firms.

But it's hard to get it I think.

In the real world it's a battle.

They don't want to tell you.