Morgan Stanley reported upbeat third-quarter earnings on Thursday. But its numbers provide a lesson in why it's sometimes necessary to journey down rabbit holes to understand complex Wall Street firms.
The issue has to do with something called “value at risk.†This is an industry term for one type of stress tests that Wall Street banks perform on their assets. These tests estimate how much money a bank could lose under adverse market conditions. Value-at-risk tests are hardly fail-safe. They didn't predict the scale of losses that occurred during the financial crisis. And changes to a value-at-risk model helped cause JPMorgan Chase's multibillion-dollar losses on derivatives earlier this year.
Morgan Stanley said on Thursday that it had changed its value at risk model. Like JPMorgan, it changed the model to comply with new international regulations that American banks must abide by. Notably, the effect of the change was to reduce the estimated amounts that Morgan Stanley could lose in one day in plummeting markets. Under the new methodology, Morgan Stanley's bond traders might lose $53 million. Under the old, it was $76 million.
One temptation is to ignore value at risk altogether because it comes from a black box and has proved of little worth when times get tough. But that might be mistake. Value at risk measurements play a key role in setting capital, which is the financial buffer that banks hold to absorb any potential losses.
Since the financial crisis, regulators have forced capital higher and introduced changes to make capital more resilient. Banks themselves know they need capital. On the other hand, they are tempted to hold less, because setting money aside to absorb losses can reduce the funds they have to make bets. Naturally, then, banks will look for inexpensive ways of boosting capital ratios.
Value at risk may provide that opportunity. Lower loss estimates from value at risk can give a boost t o capital ratios, without anything else changing.
Indeed, on Thursday, Ruth Porat, Morgan Stanley's chief financial officer, said that the value at risk changes had given a capital ratio a “modest benefit.†The new model places more emphasis on market movements toward the end of the four-year period it measures. Right now, that leads to lower loss estimates because it ends up putting less emphasis on the 2008 financial crisis and the two turbulent years that followed.
Morgan Stanley said that its regulators had approved the model changes for use in its capital calculations. Goldman Sachs has yet to give out new value at risk loss estimates.
This area could yet spring some nasty surprises. Believe it or not, the new regulations actually demand that banks start doing an additional, more stringent value-at-risk test. This is known as “stressed V.A.R.†European banks have started to report these “stressed†results â€" and they are far higher than re gular value-at-risk readings. In all likelihood,American banks will also have to do this in the first quarter of next year.
In an interview, Ms. Porat said that Morgan Stanley is already using the “stressed†value at risk to help calculate capital requirements. That implies there will be no unpleasant surprises early next year when the stressed approach becomes mandatory. But nothing down the rabbit hole is certain
