Is Var procyclical or countercyclical

[saurabhpal49]

As per logic if there is economic boom var has to be low and high if there is bust.which implies it is countercyclical. However if time varying volatility is incorporated Var tends to be procyclical
Can some one explain why?

 

[emilioalzamora1]

Hi,

No it is just the other way round. VaR moves (very roughly speaking) in lockstep with the economic cycle. It is low during booms and high during busts.

Let me first cite the genius Max Wong and his book Bubble Value-at-risk (page 7-8):

The idea of procyclicality is not new. In a consultative paper, Danielsson and colleagues (2001)4 first discussed procyclicality risk in the context of using credit ratings as input to regulatory capital computation as required under the Internal Rating Based (IRB) approach. Ratings tend to improve during an upturn of a business cycle and deteriorate during a downturn. If the minimum capital requirement is linked to ratings—requiring less capital when ratings are good—banks are encouraged to lend during an upturn and cut back loans
during a downturn. Thus, the business cycle is self-reinforced artificially by policy. This has damaging effects during a downturn as margin and collateral are called back from other banks to meet higher regulatory minimum capital.

This danger is also highlighted in the now-famous Turner Review,5 named after Sir Adair Turner, the new Financial Service Authority (FSA) chief, who was tasked to reform the financial regulatory regime. The review has gone furthest to raise public awareness of hard-wired procyclicality as a key risk. It also correctly suggested that procyclicality is an inherent deficiency in the VaR measure as well. Plot any popular measure of value at risk (VaR) throughout a business cycle, and you will notice that VaR is low when markets are rallying and spikes up during a crisis.

This is similar to the leverage effect observed in the markets—rallies in stock indices are accompanied by low volatility, and sell downs are accompanied by high volatility. From the reasoning of behavioral science, fear is a stronger sentiment than greed. However, this is where the analogy ends. The leverage effect deals with the way prices behave, whereas VaR is a measurement device (which can be corrected). The Turner Review says our VaR riskometer is faulty—it contains hardwired procyclicality. Compounding the problem is that trading
positions are recorded using mark-to-market accounting. Hence, in a raging bull market, profits are realized and converted into additional capital for even more investment just as (VaR-based) regulatory capital requirements are reduced. It is easy to see that this is a recipe for disaster—the rules of the game encourage banks to chase the bubble

There is also an outstanding paper published by H.S. Shin and Tobias Adrian about this called 'Procyclical Leverage and VaR':

'...we documented that the leverage of market-based financial intermediaries was procyclical - that is, leverage is high during booms and low
during busts. Procyclicality of leverage is the mirror image of increased collateral require-ments (increased “haircuts”) during downturns, and Geanakoplos (2010) and Gorton and Metrick (2012) have examined how the risk-bearing capacity of the financial system can be severely diminished when leverage falls due to an increase in collateral requirement...'


'...The evidence on the balance sheet management of the …nancial intermediaries in our sample points to the VaR Rule being an important determinant of the leverage decisions of
the …nancial intermediaries in our sample. The Value-at-Risk rule gives rise to procyclical leverage in the sense that leverage is high in tranquil times when unit VaR is low, while leverage is low in more turbulent market conditions when unit VaR is high. Translated in terms of risk premiums, leverage is high in boom times when the risk premium is low...'


This is backed up J.P. Landau (Deptuty Governor of the Bank of France) in a BIS note saying:
http://www.bis.org/review/r090805d.pdf

First, risk management techniques: tools used to measure and value risk, such as VaR are naturally and strongly procyclical, especially when constructed with very short data series. Risk management practices hardwired to valuations (such as margin calls) strongly amplify fluctuations in leverage and may lead to fire sales and "one sided" markets

Based on this it is well understood that the new Basel III guidelines focus on countercyclical risk measures: raising the capital requirements for banks in tranquil times and easing the capital standards in turbulent times when new credit (easy access to money) is highly needed in certain fields of the market.

 

[David Harper CFA FRM]

Thank you @emilioalzamora1 these links are super-helpful, I find. The FRM (as a narrower point) has a somewhat checkered history with the term "procyclicality;" e.g., in early years, it tended to refer to procyclical credit ratings (https://forum.bionicturtle.com/threads/procyclicality.682) then more recently the emphasis was, exactly to your point, how to manage the pro-cyclical tendency (aka, to effect counter-cyclical influence) of risk measures, such a VaR, that might depend too much on recent historical data (e.g., 412.2 https://forum.bionicturtle.com/thre...expected-positive-exposure-eepe-gregory.7758/ ... "In order to determine the counterparty credit risk capital charge, the Basel III regulatory framework requires the calculation of an effective expected positive exposure (effective EPE or EEPE) with stressed parameters. In regard to Basel III's stressed EPE, specifically, "Expected positive exposure (EPE) must be calculated with parameter calibration based on stressed data. This has arisen due to the procyclical issues of using historical data where non-volatile markets lead to smaller risk numbers, which in turn reduce capital requirements. This use of stressed data is also intended to capture general wrong-way risk more accurately.")

I just wanted to add to your post where I get stuck here: it's really in the the initial definitions. I really like Landau's answer to the question, What is procyclicality? His answer: "strictly speaking, procyclicality refers to the tendency of financial variables to fluctuate around a trend during the economic cycle. Increased procyclicality thus simply means fluctuations with broader amplitude." That's narrow enough for me to comprehend, and i might paraphrase in this way: procyclicality is simply when a variable is correlated with the economic cycle (and recall we have a working definition of "cycle" per Diebold).

This helps me because, while Landau flat out asserts that "First, risk management techniques: tools used to measure and value risk, such as VaR are naturally and strongly procyclical, especially when constructed with very short data series,"
the excellent Tobian Adrian source needs to make assumptions and connect the dots--namely via leverage effect--in order to assert, finally, that "Our result implies that when overall risk in the financial system increases after a shock (e.g. a change in theta), the bank must cut its asset exposure (through deleveraging) to maintain the same probability of default to additional shocks as it did before the arrival of the shock." So Tobian isn't so blunt, it's really just something like "if a bank employs this particular Merton-style/leverage-based/constant PD VaR approach, then it exacerbates or amplifies the cycle." And we call that procyclical.

But i find it easier to manage this by defining "procylical" first as a narrow thing: a variable that correlates with economic cycle, or as Launda says, tends to fluctuate with the cycle. Is VaR thusly procylical? Strictly, I think it really would depend on the VaR approach employed! Then, separately, there is discussion of a what Jorion calls a "procylical effect" which is the tendency of action (e.g., buy or sell assets) to amplify the economic cycle. I am just focused on definitions here because rather than say "VaR is procyclical" which always confuses me, I prefer something like "Most VaR approaches, especially those dependent on recent, short-term data, tend to have a pro-cyclical effect." I hope that's additive.