Abstract
Despite the use of VaR as a means to control risk, using VaR can have the opposite effect. VaR is used by bank and insurance regulators more than any other risk measure. A value-at-risk (VaR) constraint on the probability that future firm equity value will be less than a floor, when the floor is zero, is also a constraint on the probability of ruin. A manager who maximizes his firm's expected equity value subject to a VaR constraint, when the firm is in bad financial health, pays a premium for financial instruments that increase his firm's volatility and does the opposite when the firm is in good financial health. Regulations with VaR or probability-of-ruin constraints may increase banks' or insurers' volatility in bad economic conditions. Hence the use of VaR may increase the instability of the global financial network when the financial system is more vulnerable. Basel II regulations, via the Internal Based Ratings Approach, encourage banks with greater systemic risk, the large banks, to use VaR constraints thereby encouraging the banks to which the global financial system is more vulnerable to take on greater risk when it is more vulnerable.
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