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JRF
8,1 Value-at-risk concept by Swiss
private banks
Andrey Rogachev
72 Group Risk Management, F. Hoffmann-La Roche Ltd, Basel, Switzerland

Abstract
Purpose – The purpose of this paper is to consider the problem of using the Value-at-Risk (VaR)
technique and examine its practical implementation by Swiss Private Banks.
Design/methodology/approach – The paper is based on a survey originally undertaken in 2003
and updated in 2005. The research results provide details on how asset and portfolio managers
understand and apply VaR methodology in their daily business.
Findings – From the banks’ perspectives, VaR has both positive and negative points. It is like a
common denominator for various risks. The reason is that VaR is used by portfolio managers as
comparable risk measurement across different asset classes and business lines.
Originality/value – This analysis shows how banks can implement VaR concept more effectively
through its practical implementation areas in: portfolio management decisions and asset allocation; the
“what-if” modeling of candidate traders; and measuring and monitoring market risk.
Keywords Value analysis, Banks, Risk analysis, Asset management, Financial risk, Switzerland
Paper type Research paper

The Journal of Risk Finance
Vol. 8 No. 1, 2007
pp. 72-78
q Emerald Group Publishing Limited
1526-5943
DOI 10.1108/15265940710721091
Introduction
Since Value-at-Risk (VaR) first received wide representation in July 1993 in the Group
of Thirty report (Group of Thirty, 1993), the number of users of – and uses for – VaR
increased significantly. It is important to recognise that the VaR technique has gone
through considerable refinement, including essential process changes since it
originally appeared. Researchers in the field of financial economics have long
distinguished the importance of measuring the risk of portfolio and financial assets or
securities (Campbell et al., 2001; Culp et al., 1998; Simons, 2000; Tan and Gautham,
1999). In recent years, the growth of trade activity and instances of financial market
instability have prompted new studies underscoring the need for market participation
to develop reliable risk measurement techniques (Glasserman et al., 2002; Martin et al.,
2001; Rockafellar and Uryasev, 2000; Rogachev, 2004). Nowadays the VaR is a
standard risk measurement that is applied as an approach to risk management, which
was emerging as the industry standard either by choice or by regulation. The VaR
measures focus directly, and in currency terms, on a major reason for assessing risk in
the first place – a loss of portfolio value. That is why VaR as a modern risk
measurement for customer portfolios is a special point of research here.
VaR has become in recent years the most important benchmark for the measuring
and estimation of risk in portfolios of diverse and often complex instrument. VaR is a
single summarising statistical measure of possible portfolio losses due to normal market
movements. Moreover, VaR aggregates all of the risks in a portfolio into a single number
suitable for use in the boardroom, reporting to regulators, or disclosure in an annual
report. In estimating VaR it is important to not only provide the most accurate
forecasting as possible, it is especially important for a bank to know if a model tends to
underestimate or overestimate VaR. Risk managers must consider how much risk they Value-at-risk
are taking, if they have enough capital to take it and whether they are getting adequately concept
paid for taking that risk. These central questions of risk management hinge on the
meaning of the term “risk”. We analysed how VaR was applied in the daily routines of
the Swiss private banking industry. VaR models, understanding the concept and its use
for customers were at the centre of this precise and practical research.
73
Key findings
.
Nearly one-third of respondents report that their banks currently implement a
VaR concept.
.
The risk policy of most Swiss private banks is based on risk responsibility, risk
management and risk control.
.
Portfolio and asset managers are significantly involved at the current stage of
risk communication to private banks’ clients for at least half of the banks where
VaR technique is broadly used.
.
Three main applications of VaR in asset and portfolio management are decision
making for assets allocation, “what-if” modelling, measuring and monitoring of
market risk.
.
Approximately three-fourths of the banks using the VaR concept apply the
historical simulation technique in estimating the process. In addition, some used
the variance-covariance approach, Monte-Carlo method and scenario simulation.
.
Findings confirm a high expectation and optimism concerning the role of VaR
concept in risk management practise. The quantity of the banks applying VaR
technique is getting larger and larger, not only as a result of regulatory
requirements.
.
Almost all banks are missing the dynamic approach to VaR estimation. A more
specific problem of practical implementation of the VaR concept in portfolio and
asset management is how to make market risk estimating more precise.

Survey and its results

The results presented here are based on a questionnaire study undertaken in 2003 and
updated in 2005. The questionnaires were sent to the heads of risk management of
major private and regional banks in East Switzerland. Excluded from the survey were
big banks (UBS, Credit Suisse) as well as foreign and Swiss exchange banks. We
addressed 57 Swiss banks. They corresponded to about 14 percent of the total number
of registered banks in Switzerland. From these 33 banks which sent us responses (see
Figure 1), the resulting response rate was 58 percent. This is high response for a survey
of this type. It was initiated by the Basle Banking Committee in the last few years. One
may assume that the high participation rate was due to the strong interest the banks
took in the problem discussed. This is also reflected in the hierarchical positions of the
respondents: about a quarter of the questionnaires were filled out by a member of the
board. Moreover almost all questionnaires were answered by senior risk managers.
Being small banks, about 64 percent (see Figure 2) of the responding banks had not
introduced VaR in their own risk management system. Most of them noted that their
banks did not apply the VaR concept at that time, but that they had a great interest in
JRF
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74

Figure 1.
Survey of Swiss Banks

Figure 2.
Application of
value-at-risk concept

this risk measure. Actually just 36 percent of the responding banks used VaR
reporting. This left us with a total sample of 12 banks for further analysis. All of these
banks used the VaR for internal purposes such as legal reporting, internal controlling,
investment monitoring. Half of them also made possible the use of the VaR estimation
for big portfolios (like trading positions or institutional clients), and only one bank had
introduced the VaR for all customers.
The survey shows that the risk policy of most Swiss private banks is based on risk
responsibility, risk management and risk control. Three competence steps can be
defined. On the first level management remits measures of risk limitation and formulates
risk policy in details. Then risks are collected from the partial books and current tax
structures. Finally the bank’s management and the risk board define the responsible
groups and delegate risk supervision to them. The responsibility for the risk evaluations
of customer portfolios belongs to the daily work of every investment consultant.
However, simply with derivative instruments, like structured products, it is difficult to
calculate VaR at first sight for non-linearity reasons. In these reports, the risks of the
investments are measured and presented in a transparent manner. This is especially
important for structured products, which can behave either like stocks or like bonds,
depending on the product design and the price movement of the underlying securities.
 Portfolio and asset managers are significantly involved at the current stage of risk Value-at-risk
communication to private banks’ clients for at least half of the banks where VaR concept
concept is broadly implemented. Risk management generates a value both financially
and non-financially, e.g. protection of reputation. This thesis is comprehended by
approximately 95 percent of asset and portfolio managers in the banks with active VaR
application technique. In those banks business management is accountable for active
management of risk exposures and control functions are responsible for objective 75
check on integrity of risk taking and for setting exposure limits where appropriate.
Further we analyse the advantage of the VaR use due to asset management reply in
those 36 percent (see Figure 2) of the responding banks that apply VaR methodology in
their own risk management systems.
Asset managers make portfolio management decisions including asset allocation
across broad assets classes and/or market sectors. In addition, portfolio managers may
choose to actively implement their asset allocation choices by selecting undervalued
securities within an asset class as opposed to purchasing a passively managed index
proxy. According to about 65 respondents in the analyzed banks cluster, one of the
primary benefits of VaR for asset managers is that it facilitates the consistent and
regular monitoring of market risk. Both internal and external portfolios are included
here. Institutional investors can calculate and monitor VaR at a variety of different
levels. When calculated and monitored at the portfolio level, the risks taken by
individual asset managers can be evaluated on an ongoing basis.
The next point is the “what-if” modelling of candidate traders that is used in
two-thirds of responding banks in this cluster. VaR can be beneficial to asset managers
who wish to eliminate transactional scrutiny by top (or senior) management or
directors and trustees. In this way VaR can actually help give portfolio managers more
autonomy than they might otherwise have without a formalised VaR-based risk
management process. Nevertheless VaR will never tell an asset manager how much
risk to take. It will only tell a manager how much risk is being taken. So, VaR is a tool
for helping managers determine whether the risk to which they are exposed is the risk
they think it is and whether it is the risk of their choosing.
A third application of VaR to asset management due to our respondents (supported
by the half banks in the cluster) involves measuring and monitoring market risk using
a formal system of pre-defined risk targets or thresholds. In essence, risk thresholds
take ad hoc risk monitoring one step further and systematise the process by which VaR
levels are evaluated and discussed for portfolios and asset managers. VaR is actually a
piece of information about the distribution of possible future losses on a portfolio. The
actual profit or loss will not be known until it happens. Nevertheless the VaR is a very
useful statistic. And the primary benefit of a risk target system is the formalisation of a
risk monitoring process.
Figure 3 presents how often portfolio managers use VaR reporting in their practice.
The results show that interest of asset managers in VaR is very different from bank
to bank. Almost every bank calculates VaR for internal purposes and/or to represent
market risk. Fewer of them apply the concept for customer reporting and/or to estimate
risk for some specific finance instruments such as structured product or funds. The
reason is that some banks are absolutely sure that their customers do not understand
the VaR concept. Nevertheless many asset managers have avoided or criticised VaR
based on the notion that systematic measurements and disclosures of risk serve only to
JRF
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76

Figure 3.
Using value-at-risk by
Swiss asset managers

attenuate the autonomous nature of the investment management process. On the

contrary, measuring VaR and using it as the basis for internal monitoring and risk
targets, external risk disclosures and transactional risk evaluations can actually give
the asset manager more autonomy than if investors or senior managers are unsure of
what the fund’s market risk exposure actually are. Because the VaR does not capture
all relevant information about market risks, it is, at best a tool in the hands of a good
risk manager. The chief range of VaR applications remains through conversations with
customers.
Main majority of the banks using the VaR concept apply the historical simulation
technique in estimating the process (see Figure 4). Some use the variance-covariance
approach, Monte-Carlo method and scenario simulation in addition. Application
possibilities, simple representation, data rows and calculation speed affected the choice

Figure 4.
Used value-at-risk
estimation methods in a
practice
of estimation technique used by banks. It is interesting to note that all banks which Value-at-risk
implemented scenarios for the VaR estimating applied worst-case scenarios as stress concept
testing and half standard scenarios according the Bank for International Settlements.
Only three banks define for themselves the VaR scenarios under their own
assumptions. The bank practice showed that foreign exchange rates, equities, market
actions, underlying price rows had the largest influence on the VaR estimation.
Mathematically it reflected the exponential weights used to calculate the 77
variance-covariance matrix and volatility movements of portfolios.
Generally there are two types of bank assets: loans and marketable securities. The
latter compose the bank’s trading portfolio. For such a portfolio the VaR limit system is
very important. Unfortunately there were few banks which had an obvious limit
system. Most of the respondents implemented the general trade limits and VaR limits
for biggest portfolios. Such VaR limits were yearly constantly defined amounts, which
were periodically reviewed by senior managers. Only two banks defined limits as a
certain percentage of the current portfolio value.

Conclusions
From the bank perspectives VaR has both positive and negative points. There is no
need to explain that VaR is a unique risk figure overall for banks. It is like a common
denominator for various risks. The reason is that VaR is used by portfolio managers as
comparable risk measurement across different asset classes and business lines. VaR
not only shows the risk potential but also the combination of risk factors of different
kinds. Swiss asset managers define VaR as a synthetic indicator containing numerous
global risk data, other factors and taking the diversification effects into account. As top
level risk consolidation, the VaR services capital allocation.
But there are certain disadvantages of using VaR. First of all, this risk measure
could become a black box. The question is that extreme variations are not covered.
Therefore stress testing is often needed. Secondly, the VaR concept has strong
assumptions. There is also the problem of the few lost events. VaR as used in practice
is based on historical data. Actually it means that the VaR speaks only about history
and does not consider the future. From this point of view, VaR looks like a very
accurate number, but correlations can change and history is not always a perfect guide.
Therefore banks prefer scenarios and stress testing. On the other hand the other
estimation methods require a long computation time. Thus ad hoc analysis is not
possible. Some asset managers characterise VaR as a single risk number, which is easy
to understand; others do not use it as they find the classical methods (for example,
Greek implementation) easier to quantify risk. In summary almost all banks are
missing the dynamic approach to VaR estimation.
Finally, we would like to emphasize that risk managers are primary concerned with
the risk of events that are very unlikely to occur but could lead to catastrophic losses. A
more specific problem of practical implementation of the VaR concept in portfolio and
asset management is how to make market risk estimating more precise. Asset
managers need the risk measurement that rejects daily market fluctuation and
observes daily position changes in portfolio.
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Corresponding author
Andrey Rogachev can be contacted at: andrey.rogachev@roche.com

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