|
Introduction
MANY
banks have invested significantly in improving their
risk measurement and management in the last few years to
comply with the requirements of Basel II. In particular,
banks have invested in methods, resources, processes and
technology to assess, monitor, manage and model their
risks. Most of the effort has focused on compliance with
Basel II and other regulatory requirements, and some
banks continue to struggle with meeting these demands as
they work through the approval process. Now that the
Basel II programs within leading banks have either
become significantly mature or have virtually finished,
the following questions are often raised:
 •
What is the next challenge for the management of banks?
• Will
it be (banking) business as usual once Basel II is
implemented and digested with limited change to “the way
we do things around here”? or
• Will
leading firms find new ways to capitalize on their
substantial Basel II investments?
Modern
banks and other financial institutions already operate
in an environment where management is focused not only
on the regulatory view but also on the bank’s
relationship with rating agencies, its shareholders and
other stakeholders. Driving these circumstances are the
increasingly integrated global financial markets, which
allow potential stakeholders (i.e., shareholders and
creditors) to focus on a bank’s ability to create value,
thus driving more competition among institutions.
Together
with the effect of strengthened minimum-capital
requirements arising from Basel II, these developments
will result in a much smaller range of acceptable
capital ratios available to senior management.
Where
does the industry stand today?
The
following two core aspects need to be considered in
order to arrive at an Economic Capital (Ecap) model:
1.
Identification and measurement of all major risks; and
2.
Group-wide aggregation of these risks to arrive at Ecap.
Although
all banks, which employ Ecap, normally cover these two
aspects, in our opinion there is still a long way to go
until within the development of firms’ measurement
frameworks. The reason for why we think this is because
KPMG member-firms have seen quite heterogeneous
approaches among firms, even among those institutes,
which consider themselves “leaders of the Ecap pack.”
Identification and measurement of all major risks
One
would not dispute that there are certain banking risks
which need to be included into an Ecap framework asking,
“How much Ecap would I have to hold to protect the bank
against unexpected losses from those risks?” Examples of
such risks would include credit risk, market risk,
business risk or operational risk. On the other hand,
there are other risks which cannot be cured simply by
holding enough Ecap, and these include liquidity risk
and reputational risk.
These
risks need to be addressed differently: the former, by
assuring that even in situations of markets drying up
the bank has access to enough liquidity to avoid a bank
run; the latter, by establishing incentives and
structures to reduce damaging behavior of its employees
toward the public and by avoiding spectacular losses by
prudent decision-making.
Group-wide aggregation of these risks to arrive at Ecap
Because
many leading banks still measure their individual risks
on a stand-alone basis the need arises for Ecap
measurement to happen at a group level to aggregate the
individual risks in some way. To do this, some banks
still simply add the risk figures up; others use a
variance-covariance approach with some interrisk
correlation figures typically based on rules of thumb,
dubious benchmarks or own guesstimates; and, finally,
others use copula methods.
In
addition, none of these methods really allow the banks
to study and understand economically driven interactions
and the causalities between different risk types. This
is because the interactions between risk types are
generally too variable to be properly reflected in
either a variance-covariance or copula framework given
the static nature of their parameters. This is why we
think that Ecap models based on common macro- and
microeconomic risk drivers are the way forward.
Summary
and conclusion
The next
generation of Ecap models will probably evolve as
economic capital-risk factor models. Experience shows
that leading banks took their first steps toward a
full-fledged Ecap framework more than a decade before
discussions about Basel II had begun. Their driver was
the insight that an efficient “currency” for the overall
risks a bank faces is essential in managing its
competitive position. Experience also suggests, however,
that even these leading institutions have a way to go
before their models will converge to a common Ecap
measurement and management standard.
On the
other hand, Pillar 2 will encourage many banks to adopt
more sophisticated approaches to the use of Ecap in the
coming years. Regulation, together with the pressure of
competition and the fear of hostile takeovers sparked by
global financial markets, will thus be the driver for
Ecap measurement and management becoming the central
topic in banks’ risk and capital management over the
next decade.
(This
article is an excerpt from a thought leadership document
entitled “Basel Briefing 13” by KPMG International.
The
information contained herein is of a general nature and
is not intended to address the circumstances of any
particular individual or entity. Although we endeavor to
provide accurate and timely information, there can be no
guarantee that such information is accurate as of the
date it is received or that it will continue to be
accurate in the future. No one should act on such
information without appropriate professional advice
after a thorough examination of the particular
situation. KPMG and the KPMG logo are registered
trademarks of KPMG International, a Swiss cooperative.
For comments or inquiries, please e-mail Elizabeth R.
Locsin at elocsin@kpmg.com.ph or Gillian de Guzman at
gddeguzman@kpmg.com.ph.) |
