Economic Capital Revisited Forestalling Another Meltdown

Transcription

1 Perspective Gauthier Vincent Peter Gassmann Economic Capital Revisited Forestalling Another Meltdown

2 Contact Information Amsterdam David Wyatt Beirut Peter Vayanos Frankfurt Peter Gassmann London Alan Gemes Senior Gagan Bhatnagar Milan Vincenzo Bafunno Mumbai Jai Sinha Munich Johannes Bussmann New York Ken Favaro Senior Paul Hyde John Plansky Gauthier Vincent Senior Executive Advisor São Paulo Roberto Marchi Shanghai Andrew Cainey Sydney Vanessa Wallace Senior Tokyo Takeshi Fukushima Principal Zurich Carlos Ammann

3 EXECUTIVE SUMMARY The recent financial crisis revealed a dramatic imbalance at financial services firms between the risks they took and the capital cushion they had to protect their clients, employees, and shareholders from these risks going sour. Economic capital systems, on which financial services firms had spent untold millions of dollars for development and implementation, were designed precisely to align risk with capital management. However, these systems failed to deliver on their promise because of both technical shortcomings and managerial neglect. To avoid a repeat meltdown, the answer is not to abandon economic capital systems but rather to revive these tools to enable a culture of risk in which risk, capital, and strategic management are integrated. Only by doing this can financial firms again grow by taking more risks but this time with their growth predicated on strong capital positions. 1

4 HIGHLIGHTS Financial services firms spent untold millions of dollars on sophisticated economic capital systems that ultimately failed them. Senior management did not provide sufficient guidance for the development of economic capital systems. Risk management and capital management grew increasingly decoupled in the years preceding the financial crisis. There is no good alternative to economic capital. Financial services firms must create successful risk cultures, with economic capital as the currency of risk. Economic capital systems facilitate the right discussions among senior leaders about risk appetite, risk tolerance, and financial leverage. CAUSES OF A CRISIS If the meltdown of financial stocks in 2008 could be described in simple terms, these would suffice: Risk management and capital management at global banks and financial companies failed. The magnitude of credit losses and other write-downs clearly demonstrated that certain risks had been seriously underestimated while others had been missed altogether. On top of this, many financial institutions found themselves too thinly capitalized, prompting governments to provide fresh capital to save the banking system. More than anything else, this is the story of the failure of economic capital systems. Economic capital (EC) is the financial industry s term for how much equity capital a bank must carry to protect its shareholders against insolvency (and other stakeholders against financial distress), given its mix of assets and liabilities and its particular risk tolerance. EC systems are methodologies, algorithms, processes, and data used to assess the amount of economic capital required to cover multiple sources of risk. For instance, losses due to unexpected loan defaults or a plunge in the price of tradable securities can rapidly erode the equity account of a highly leveraged institution. In short order, this will lead to insolvency in which equity value is less than zero unless the company has a sufficient equity cushion to absorb the losses. EC systems, in theory at least, are designed to identify the requisite size of this cushion. In the last 20 years, hundreds of millions of dollars have been invested by financial services firms in sophisticated EC systems. Regulators have also spent countless hours assessing the merit of these systems and even incorporated EC in the Basel II international banking regulatory framework in 2004 as the core part of the capital adequacy process. But the notion in many boardrooms is that ultimately EC systems failed to deliver on their promise. The reasons range from technical shortcomings to management neglect. 2

5 WHY ECONOMIC CAPITAL SYSTEMS FAILED Economic capital systems missed significant sources of risk Under normal circumstances, credit exposures in loan portfolios and changes in market rates and in the values of traded securities explain most financial institution earnings volatility. Originally, EC systems were designed to translate these core risks into capital requirements. Over time, risk managers widened the scope of EC systems to take into account additional sources of volatility, such as operational and business risk (for the key sources of risk, see Exhibit 1). However, even with these expanded responsibilities, EC frameworks often omitted other sources of risk, in part because the analytics for assessing them have not been perfected. Among those neglected were funding and liquidity risk, counterparty risk, and credit risk embedded in securities (as opposed to loans); these were the very risks that wreaked havoc in financial services in the last few years. EC systems underestimated capital requirements In theory, risk exposures can be translated into capital requirements using a statistical distribution (often assumed to resemble a normal distribution) for potential losses and a certain risk tolerance. In practice, this is quite a challenging exercise. The risk events under consideration often have such low probabilities that Exhibit 1 Key Sources of Risk in Financial Services Credit Risk (including Counterparty Risk) The possibility of loss caused by the failure of a client or counterparty to meet a contractual debt obligation; associated with loans, but also with certain securities and capital market transactions Market Risk The possibility of loss resulting from changes in asset values of trading positions due to movements in market parameters such as interest rates, foreign exchange rates, commodity prices, and share prices Operational Risk The possibility of loss due to failed or inadequate processes, through human error, technical failures, or external events; includes legal risk Funding and Liquidity Risk The possibility that an institution might fail to meet its payment obligations when due because of a lack of cash and other liquid assets or that the institution s access to funding sources and new liabilities (such as deposits, debt, and capital) becomes restricted Country Risk The possibility of loss resulting from country-specific systemic risks (political and macroeconomic risks) or restrictions of payments (transfer risk) Business and Strategic Risk The possibility that changes in market conditions, the outcomes of adverse business decisions and competitor strategies, or the lack of responsiveness to other unanticipated shifts impacts earnings and capital in an unexpected way Reputational Risk The possibility of lost revenue or destruction of shareholder value due to a decline in the perception of the financial institution by several stakeholders (e.g., clients, shareholders, personnel, investors, or regulators) Source: 3

6 they are well out in the tails of the distribution curve, where the exact shape of the curve is unclear and the assumption of normality breaks down. Furthermore, in an economic world that looks less normal every day, the impact of fat tail events is often more dramatic than most models would predict. Even when individual risks can be translated into economic capital, combining capital needs across multiple risks to get to a total economic capital estimate is not as straightforward as it would seem. Merely adding up capital requirements will not do, since this would assume that the underlying risks are uncorrelated. Instead, EC systems use correlation matrices within portfolios of loans. Unfortunately, in the recent credit crisis, these matrices turned out to be too optimistic. Furthermore, certain types of risk (such as credit and market risks) that were traditionally thought to be independent seemed to move in tandem during the last three years. Managers of EC systems failed to communicate to senior management what EC systems could and couldn t do and senior management and boards failed to understand and challenge EC systems Too often, EC systems were developed and managed by quantitatively oriented, relatively junior finance professionals (typically Ph.D.s). They found it difficult to communicate, in simple and compelling language, the virtues of EC to senior management and to the organization at large. Frequently, they were also reluctant to admit the limitations of EC for fear of undermining themselves. With relatively little communication, bankers were left with the nagging belief that EC systems could not be fully trusted. Viewed another way, senior management paid little heed to EC systems, either during their development or after they were implemented. In some cases, these executives were intimidated by the analytic sophistication of EC. Or they did not have the banking and risk expertise to challenge the output of EC systems well enough. In other cases, investor pressure to release excess capital in order to boost short-term valuations was too great to bother with EC. And regulators were of little help, at least in the United States. They tended to focus on compliance with unsophisticated regulatory capital frameworks. Risk management and capital management grew increasingly decoupled In the past 10 years, many financial companies allowed the risk management function to become increasingly independent of the finance function; typically, the chief risk officer, who had previously reported to the CFO, was permitted to bypass finance and report to the CEO, often with direct access to the board. While this raised the profile of the risk management function in the organization, the unintended consequence was to gradually insulate risk and capital management from each other. In the process, EC systems, which were usually placed in the CFO s group, lost critical support from the risk team and were used less and less frequently in day-today decision making. For instance, risk officers approved or denied new business opportunities based on risk limits without costing out the associated risks against an allocation of economic capital. For all of these reasons, EC lost much of its relevance as a management tool precisely when it was needed most. Troublesome increases in risk exposures in the years preceding the financial crisis were not accompanied by corresponding increases in economic capital. In fact, financial institutions risk tolerance was rising dangerously, a troubling development that was ultimately paid for by clients, employees, and shareholders. 4

7 REVIVING ECONOMIC CAPITAL SYSTEMS The appropriate response to the failures of EC systems is not to do away with them. After all, there really isn t a good alternative. Crude and simple metrics, such as capital ratios, can play a role in limiting an institution s overall leverage and risk level. But they are not very helpful at the business or transaction level, because they are unable to fully untangle and address the deeper complexity of these financial risks. Hence, if EC systems are indispensable in the current financial services environment, a plan for reviving these tools to achieve the goal of weighing risk against economic capital at every level of the organization is imperative. This involves three steps: Restore the credibility of EC systems The analytic flaws and limitations of EC systems today must be addressed head-on. Specifically, all sources of volatility in earnings must be incorporated in EC frameworks, and correlations between risk categories must be reassessed in light of the crisis. This will require analytic refinements combined, in some cases, with simplification of assumptions so that the analytics of specific modules don t get ahead of the quality of their All sources of volatility in earnings must be incorporated in economic capital frameworks, and correlations between risk categories must be reassessed in light of the crisis. 5

8 input. In all, business judgment and experience must provide the necessary guidance for the development of new analytics. The best managers of economic capital are seasoned banking executives who have knowledge and intuition gained over several banking cycles. Ultimately, the chief risk officer and the CFO must work together to fix EC, and both should be held accountable for the quality of EC systems going forward. A single fix will not suffice. EC systems must be continuously improved. In particular, EC systems should be recalibrated periodically to account for emerging new risks and changes in the firm s overall risk tolerance. Senior management and boards must be actively involved in this exercise. Create a risk culture with EC as the currency of risk A successful risk culture is one in which emerging risks are quickly identified, debated, and acted on. This is a culture in which decision makers throughout the organization share a common framework for assessing risk and return trade-offs, and their performance is evaluated on a risk-adjusted basis. In such a framework, economic capital is at the center of risk and performance management. All risk exposures are translated into EC requirements, as far down in the organization as possible ideally, at the level of transactions and clients. Risk officers approve all new business opportunities that fall within enterprise risk limits. EC is the cost of risk associated with these new opportunities. Performance measures used for strategic planning and performance management at all levels of the organization include a charge for risk-adjusted economic capital requirements. EC is the common language business leaders throughout the organization use to talk about risk. In effect, EC becomes the organization s currency of risk, and accountability for risk and capital management are shared deeply and 6

9 widely in the organization rather than concentrated at the corporate level and divided between the risk and finance groups. Decision making is improved; it is risk-based. Business leaders at all levels of the organization understand and care about EC which, over time, contributes to the improvement of EC systems quality through multiple debates, challenges, and suggested refinements. Manage to economic capital EC can and must be an important tool to manage the capital position of large financial institutions. Boards and management teams should use economic capital as critical input in deciding their firms optimal level of financial leverage given their overall risk appetite (i.e., the overall volatility of earnings with which they are comfortable) and risk tolerance (i.e., the probability of financial distress they target). Other significant inputs include regulatory capital considerations and competitive benchmarks. Most important, EC must be senior management s primary tool for allocating the capital the company has so that it is put to its most productive uses within a portfolio of businesses, thereby increasing the company s capital productivity over time. One of EC s greatest values is that it facilitates the appropriate discussions about risk management among company leaders, who must address these questions: What risks are we facing as an organization? Any emerging new risks? What should we do about these risks hold more economic capital, absorb potential losses, cover risks by hedging, sell risky assets, exit businesses? If our EC requirements are increasing relative to the capital we hold, are we increasing our firm s risk appetite or is our risk tolerance changing? Of course, these are the very questions that should have been at the center of debates in all financial services firms in the years leading up to the credit crisis. One of economic capital s greatest values is that it facilitates the appropriate discussions about risk management and capital management among company leaders. 7

10 CONCLUSION As the financial crisis wanes, many boards and management teams at financial firms are extremely aware of the need to reassess their overall enterprise risk framework and practices to avoid a repeat of the recent collapse. Such broad reviews include risk governance, risk processes, supporting technology, and data. In our view, a rehabilitation of economic capital systems must be central to these efforts. The failure of EC systems during the crisis should not be interpreted as a call to jettison the tool and return to more primitive ways to manage capital. Rather, it should be motivation to use EC to develop a superior enterprise-wide risk and capital management capability. The crisis has demonstrated that such a capability can be an important source of strength and competitive advantage in the long run; without it, financial services firms will continue to carry a heavy liability. 8

11 About the Authors Gauthier Vincent is a senior executive advisor with s financial services practice in New York. He advises senior management at banks and financial companies on corporate strategy, managing for value, and business unit growth strategies. He has 15 years of experience in financial services as a management consultant, an investment banker, and a bank executive. Peter Gassmann is a partner with s financial services practice in Frankfurt. He focuses mainly on risk, capital, and portfolio management; business strategy; and operating models for financial institutions. Peter has 15 years of experience in financial services as a management consultant and as a bank executive with a leading European universal bank. 9

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