Bubble Value at Risk: A Countercyclical Risk Management Approach, Revised Edition

Chapter 3

Preprocessing

Before we explore the different VaR methodologies in Chapter 4, we need to introduce the building blocks used by VaR calculation—in particular, how positions in a portfolio are mapped to a set of risk factors and the generation of scenarios from these risk factor data. This preprocessing step represents the data aspect of VaR and forms the crucial first half of any VaR system.

3.1 SYSTEM ARCHITECTURE

To gain a perspective of how banks build and maintain their risk management systems, it helps to look at a typical risk management architecture. A good design incorporates the so-called front-to-back architecture within a single system. Unfortunately because of the merger mania in the late 1990s, many banks inherited legacy systems that were then interfaced together (loosely) by their in-house risk IT. In addition, the outsourcing mania in recent years may have moved the risk IT support to a different continent. Such a disconnect creates many weak links in the information chain. Some of the resulting problems could be incomplete position capture, incompatible rates and risk factors across systems, lack of risk aggregation tools, and so on. In the extreme case, risk information becomes opaque and questionable, which could lead to problems in hedging activities and risk monitoring.

Figure 3.1 shows a stylized system architecture. The upper part represents the risk management system while the lower part represents the trade booking system. Both systems call on ...