Value at Risk, Legislative Framework, Crises, and Procyclicality: what goes wrong?

This study highlights some deficiencies of the stock markets’ risk legislation framework, and mentions how investment companies turn these deficiencies to their advantage in order to avoid the increased cost and the complexity of the econometrically advanced and more efficient risk models. We apply variance-covariance (or Delta Normal) Value at Risk model, adopting the UCITS (CESR (2010)) guidelines. The main scope of this study is to show that the current legislative framework does not give incentives for more representative Value at Risk (VaR) estimations, and for this reason, in many cases conventional VaR models are applied. The empirical findings show that the conventional VaR models not only fail to provide information for the upcoming financial crises, but also contribute to such phenomena as procyclicality and overreaction in the stock market. This study is mainly focused on CESR(2010) guideline, but it could be useful for any similar legislative framework, such as the Basel Accords (BCBS (1996)). Finally, we empirical show how some test that could be added in the current financial framework could reduce the procyclicality issue for a more sustainable investment environment.