Financial institutions should beef up their trading risk estimates by using a variety of methods to estimate their exposures, says Standard & Poor’s Ratings Services in a new report today.

Value-at-risk is the most commonly reported measure of market risk used by financial institutions, S&P notes. But it suggests that VaR should ideally be used in conjunction with other risk measures such as expected shortfall and stress testing.

“VaR has been around for more than a decade now, but the understanding of its benefits and limitations remains spotty within the investor community,” says Standard & Poor’s risk management specialist Prodyot Samanta.

“Clearly, VaR is a significant and useful step forward; it can be applied to any financial instrument, portfolio, or risk factor and can be used as a measure of the relative riskiness among sub-portfolios. To that extent, Standard & Poor’s prefers that an institution have a disciplined approach to calculating VaR, as the spillover effects of this process in terms of infrastructure and data requirements are beneficial to the overall risk awareness of the institution,” he says.

“However, VaR has some severe limitations that, if not properly appreciated, can lull a company into a false sense of security,” Samanta notes.

“For instance, VaR lacks the criteria to provide a consistent measure for comparing the relative risk appetite across institutions, as the assumptions used by firms in calculating VaR can be vastly different and have varying degrees of precision,” he says. “In addition, as a stand-alone measure VaR ignores the extent of tail risk that an institution is exposed to, especially under abnormal market conditions.”

“Expected shortfall and well-designed stress tests are excellent complements to VaR, as they capture tail risk and provide for a more meaningful assessment of the institution’s risk profile,” he says.