Fallacies about the effects of market risk management systems

Abstract

ABSTRACT This paper takes another look at allegations that risk management systems have contributed to increased volatility in financial markets, with the particular example of the summer of 1998. The analysis starts with a review of the literature on the effect of financial engineering on financial markets. The evidence is that financial innovations reduce volatility in financial markets, but they seem to be systematically blamed for the opposite effect. The paper also provides new evidence on the potential effect of VAR-based market risk charges for commercial banks under the Basel Accord. I show that VAR-based regulatory capital charges cannot plausibly be blamed for the volatility of 1998 due to their very slow response to market movements.

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