1.9 History of Value-at-Risk
The term “value-at-risk” (VaR) did not enter the financial lexicon until the early 1990s, but the origins of value-at-risk measures go further back. These can be traced to capital requirements for US securities firms of the early 20th century, starting with an informal capital test the New York Stock Exchange (NYSE) first applied to member firms around 1922.
1.9.1 Regulatory Value-at-Risk Measures
The original NYSE rule6 required firms to hold capital equal to 10% of assets comprising proprietary positions and customer receivables. By 1929, this had developed into a requirement that firms hold capital equal to:
- 5% of customer debits;
- 10% (minimum) on proprietary holdings in government or municipal bonds;
- 30% on proprietary holdings in other liquid securities; and
- 100% on proprietary holdings in all other securities.
Over time, regulators took over responsibility for setting capital requirements. In 1975, the US Securities and Exchange Commission (SEC) established a Uniform Net Capital Rule (UNCR) for US broker-dealers trading non-exempt securities. This included a system of “haircuts” that were applied to a firm’s capital as a safeguard against market losses that might arise during the time it would take to liquidate positions. Financial assets were divided into 12 categories such as government debt, corporate debt, convertible securities, and preferred stock. Some of these were further broken down into subcategories primarily according to maturity. To reflect hedging effects, long and short positions were netted within subcategories, but only limited netting was permitted across subcategories. An additional haircut was applied to any concentrated position in a single asset.
Volatility in US interest rates motivated the SEC to update these haircuts in 1980. The new haircuts were based upon a statistical analysis of historical market data. They were intended to reflect a .95-quantile of the amount of money a firm might lose over a one-month liquidation period.7 Although it would not have been called such at the time, this was a value-at-risk metric. The SEC’s calculation for haircuts was a value-at-risk measure.
Later, additional regulatory value-at-risk measures were implemented for banks or securities firms, including:
- the UK Securities and Futures Authority 1992 “portfolio” value-at-risk measure;
- Europe’s 1993 Capital Adequacy Directive (CAD) “building-block” value-at-risk measure; and
- the Basel Committee’s 1996 value-at-risk measure based largely upon the CAD building-block measure.8
In 1996; the Basel Committee approved the limited use of proprietary value-at-risk measures for calculating the market risk component of bank capital requirements. In this and other ways, regulatory initiatives helped motivate the development of proprietary value-at-risk measures.