MSCI Barra’s (NYSE: MXB) acquisition of RiskMetrics (NYSE: RISK) unites two market leaders in systems used by the asset management industry to calculate their Value at Risk (VaR). Once the firms are merged, it is possible that the majority of the global asset management industry will be calculating VaR using models and systems produced by just one company. This will make it more likely that these firms will take similar positions, which will increase systemic risk in the financial sector.
Currently the methodologies used by MSCI Barra and RiskMetrics are radically different, as are their perspectives on risk to clients. The need for cost savings and product consistency must mean that, following the merger, all their clients will be seeing risk in the same way. And the brand power of two industry giants joined together will make it more likely that other approaches will not be taken into account as excessive faith will be put into the risk figures produced by this huge company.
This spells danger, both for investors relying on such figures and for the financial system as a whole. A rule of markets is that if everybody believes in the same thing it will be given too much weight, and the potential losses from an alternative outcome are considerable.
The scenario would be similar to a merger of the two largest credit rating agencies, Standard & Poors and Moody’s. While the merged company would benefit from cost savings and would enjoy substantial resources for carrying out detailed and expert credit analysis, the public loss of a different perspective on credit risk would surely outweigh the private gain.
Once a specialist topic for quantitative experts, the measurement of Value at Risk entered the mainstream when its use contributed to the banks’ underestimating of their capital needs during the credit crunch. Nicolas Taleb, in particular, has been a trenchant critic of the naive use of risk calculations saying, in relation to VaR, that: “It is the uniqueness, precision and misplaced concreteness of the measure that bother me.”1
The Turner Review2 also criticised VaR calculations where they were based on short term observations, which led to the pro-cyclicality of risk sensitive behaviour. This meant excessive risk was being taken based on benign conditions at the time, not taking account of less favourable longer term trends.
The clear conclusion of the post credit crunch analysis is that risk cannot be boiled down to a single number and that a multiplicity of measurements and analyses are needed in order to gain a full picture of possible exposures.
Peter Ainsworth, managing director of EM Applications, said: “Although a specialist area, the credit crunch demonstrated what a key role in global financial stability is held by the methods used to calculate investment risk. While there is always a need for advances in the methods used, it is also important for a diversity of methods to be used as this is the best guarantee of overall stability. MSCI Barra with RiskMetrics will hold a dominant position in methods used for investment risk estimation, which has the potential to lead to concentrated positions and systematic risk.”
