Value at Risk, or VaR, as helpfully summarized by Wikipedia, is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level. VaR is a mathematical model. Now, it appears, the model is also a source of risk.

Bloomberg (Keoun, 1 June) reports this morning that a string of daily losses exceeding the VaR can be a warning that the formulas are flawed or that markets have turned unusually volatile. Bloomberg notes that the Office of the Comptroller of the Currency advised banks last year to closely scrutinize the possibility that computer models used to calculate VaR might not be properly designed or calibrated. “The use of models invariably presents model risk, which is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports,” according to an April 4, 2011, document from the OCC, which supervises JPMorgan’s primary banking subsidiary. “Model risk can lead to financial loss, poor business and strategic decision-making or damage to a bank’s reputation.”