Risk and Capital Management – An Overview

1. Introduction
An interesting discussion is currently taking place between the banking industry and its supervisors regarding the adoption of a models-based approach to measuring credit risk for regulatory capital purposes. Such a discussion would have been unthinkable just a few years ago and is evidence of the impressive advances in risk measurement that have been made by the industry in a relatively short space of time. This rapid pace of change contrasts with the initial slowness that banks exhibited towards the adoption of new capital management techniques, at least relative to some other industries. This is understandable since, until the end of the 1970s, the financial sector was so heavily protected that there was practically no need to worry about the efficient allocation of resources. Unfortunately, this delay may in part explain some of the recent experiences where institutions suffered large losses – and consumed large amounts of capital. Some of the most notable examples are corporate lending just about everywhere, but especially in Asia, propertyrelated lending in the last recession and inadequate operational risk management (most notably the Barings case). The excess of capital that had flowed into the financial system might also have contributed to these events: as the capital held by an institution increases, the ability to generate a sufficient return on equity decreases, inducing the institution to take on riskier activities. Ironically, this build up in capital occurred partly in response to calls from regulators for institutions to increase their capital ratios, ie the actions taken to prevent banks assuming too much risk may actually have encouraged them to take on more risk. This raises the question of whether regulators’ attempts to achieve an ‘appropriately’ capitalised financial system are damned by an inherent dilemma. If institutions are allowed to remain thinly capitalised, they may be encouraged to lend recklessly or expand beyond their means. Yet, if institutions are forced to increase capital holdings, after a while they may become so flush with capital that they are again encouraged to lend recklessly, this time in an attempt to improve their return on equity. The recurrence of loss making events, such as those mentioned above, has led to the assertion that many financial institutions (commercial banks, insurance companies and, more recently, hedge funds) fail to learn from past mistakes. In fact, a cynic might suggest that financial institutions have a memory span equivalent to

Chris Matten*
5

that of a goldfish: apparently a goldfish’s memory span is so short that each revolution of the bowl is a completely new experience. This assertion is supported by the behaviour of many banks at different stages of the credit cycle. Economic expansion causes banks to become optimistic, perhaps even careless. Along comes a recession, often sparked by an official tightening in interest rates in response to precisely the easy credit which banks have been granting. Loan defaults rise, and banks lose money and rein in lending, making the recession that they are so concerned about a foregone conclusion. As Figure 1 shows, changes in financial system lending tend to lag the economic cycle. Typically lending does not take off until after the recession is over – it seems to take banks one to two years to digest the level of loan losses. The consequence of this is that banks do not extend credit at a time when the economy needs it most. Hopefully, the increasing focus within the industry on dynamic provisioning will at least partially address this problem.1 Dynamic provisioning forces institutions to acknowledge losses sooner with the consequence that, when the economy turns upwards, institutions should be more ready to provide credit. This paper provides a broad overview of risk and capital management in financial intermediaries. Section 2 considers the role of capital in financial institutions

Figure 1: Australian Financial System Credit and Economic Activity
Yearly Percentage Changes
% 25 20 Total credit 15 10 5 Nominal GDP 0 -5 84/85 87/88 90/91 93/94 96/97 0 -5 15 10 5 % 25 20

Source: APRA and Australian Bureau of Statistics.

* Head of Group Capital Management, National Australia Bank. 1 See Buttle’s response to this paper for further discussion of dynamic provisioning.

3 For most financial institutions. as specified in the Basel Accord. The consequent erosion of capital levels began to trouble supervisors. Capital and Financial Institutions At the simplest level. as well as unexpected or improbable losses. of course. For a bank. whilst leaving the institution able to operate at the same level of capacity. put the relationship between supervisors and institutions under intense pressure. This requires that the company’s assets exceed its liabilities such that the company is solvent. the ideas underlying the concept of performance measurement are introduced and the techniques that banks use to allocate capital are briefly examined. resulting from the collapse of the Bretton Woods exchange rate agreement. known as the 1988 Basel Accord 2. to do otherwise could undermine the soundness of the institution. while the second tier (Tier Two) includes items such as ‘hidden’ reserves. over lending to lowly-rated organisations in a bid to come out in front of the pack. Supervisors tightly restricted the activities banks were permitted to undertake. There are. While this simple rule is well established. In some countries. for example. unrealised gains on investment securities and medium. for example. The only way to address the situation without increasing the competitive differences between countries was at the international level. these restrictions extended as far as dictating the interest rates that could be charged on customer deposits. and the potential for contagion within the banking system. many different definitions of capital. Ultimately. For most of this century. proved very successful until the middle of the 1970s. Hence. Section 6 concludes with some consideration of the dangers in becoming too reliant on models. and some thoughts on future developments in the area of risk measurement. unidentified losses. ranging from the very narrow ‘equity plus stated reserves’ through to a measure that encompasses subordinated debt. entities.1. While these trends may have reflected broader economic developments. as the prospect of large institutional failures loomed ever larger. Regulatory capital uses a two-tier concept. Capital ratios in a number of countries have certainly risen since the introduction of the Accord. banks’ capital ratios rose from the late 1980s to the middle of the 1990s (see Figure 2). Note that this Committee was previously called the Committee on Banking Regulations and Supervisory Practices.to long-term subordinated debt. be it a deposit-taking institution or a corporation. is discussed in detail in Section 4. a third tier (short-term subordinated debt) is included for the sole purpose of meeting market risk capital adequacy requirements. but rather as part of the business itself. While much criticism has been directed at the ‘crude’ nature of the 1988 Accord. . Its membership comprises representatives from the G10 group of countries (plus Luxembourg). Section 5 provides a brief overview of the state of play with regard to the measurement of other risks faced by financial institutions. ensured that banks could operate without fear of takeover or the fear of losing market share to outside entities. a substantial increase in exchange rate and interest rate volatility. The first tier (Tier One) consists of share capital and disclosed reserves. The result was somewhat predictable: an industry which was unaccustomed to competitive pressures suddenly became prone to excess. this tension led to a process of deregulation and the exposure of financial institutions to the cold winds of competition. and highly protected. In return for this high degree of regulation. banks have been highly regulated. suggests that a bank’s capital base should be sufficiently large to absorb even relatively unlikely events. the amount of capital held must cover both ‘normal’ or expected losses. The intermediation role played by banks. changes in regulatory requirements undoubtedly played a role in their emergence. In Australia. thereby protecting depositors. a common minimum framework was introduced across countries to determine appropriate capital levels on the basis of the riskiness of institutions’ assets. This framework. Figure 2 is based on regulatory capital. is to provide creditor protection.Chris Matten 6 and reviews the events which led to the introduction of one of the most basic capital allocation model used in the banking industry: the Basel Capital Accord. At this time. In many countries. Hence. which was designed to ensure the stability of the financial system. In Section 3. banks were protected from competitive forces. Strict control over the issue of 2 3 See Basel Committee on Banking Supervision (1988). the role of capital in any company. Deposit-taking institutions can also be distinguished from other companies in that one of their main sources of finance (ie customer deposits) cannot be viewed as external funding of the business. who are acting to maximise the 2. the role of capital is to act as a buffer against future. it cannot explain the relatively high levels of capital that banks hold. its success in both levelling the global playing field and improving the capital adequacy of banking systems around the world is undeniable. This arrangement. banking licenses. Section 4 outlines the existing regulatory rules for credit and market risk and considers the rationale underlying the use of internally developed models for regulatory capital purposes.

all of this aligns with the classic corporate finance proposition that projects should only be undertaken if they earn at least the cost of equity. exceeding the market’s expectations will result in an increase in shareholder value. in that no actual Jun 90 Jun 92 Jun 94 Jun 96 Jun 98 Source: APRA. Correspondingly. Tax considerations and regulatory requirements are obvious determinants.1). banks have two choices: either they can increase the amount of return per dollar of equity. The term ‘capital allocation’ refers to the process of determining a notional calculation of the amount of ‘economic capital’ underpinning each of the businesses undertaken. or they can decrease the amount of equity required per dollar of target return. In short. Again. with the focus on the latter flowing from the need to increase return if the size of the balance sheet was to grow. A financial institution’s capital structure will be driven by a number of factors. this has led to a much greater emphasis on capital management within financial institutions. Of course. During the period of deregulation in the 1980s. as measured by the volume of assets on the balance sheet. by return on equity and the creation of shareholder value. whereas failing to meet those expectations will result in a destruction of value. to a much larger degree. The higher the amount of capital maintained. there is no magic formula to determining the appropriate amount of . for example. is the maximisation of the returns that shareholders receive on their equity investments. the typical goal assigned to a loan officer was to increase the bank’s market share (ie asset growth) and to increase interest earnings (ie profit growth). In more recent times. Yet. many banks now hold capital significantly in excess of this regulatory minimum. the primary focus of many banks was on increasing the size of the institution. In turn. Tier One capital must comprise at least 4 per cent of risk-weighted assets. Essentially. In general. banks will use debt for at least a portion of their capital needs owing to its flexibility. (This is distinct from the investment of physical capital. There are numerous reasons put forward for why this might be the case. The absolute amount of capital held will also depend on a range of factors. management behaviour has tended to be driven. Perhaps the excess is imposed by market forces – such as pressure from rating agencies for institutions to hold a level of capital that the agencies feel is commensurate with that institution’s credit rating. Instead. return for shareholders. The Basel capital adequacy framework is founded on a minimum capital ratio of 8 per cent of ‘risk-weighted’ assets (as defined in Section 4. Although not ‘rocket science’. until recently this focus on return was surprisingly absent from the Boardrooms of most banks. is usually most appropriate. ie shareholders’ equity. including financial institutions.Risk and Capital Management – An Overview Figure 2: Aggregate Capital (Tier One) Ratio Australian Banking System % 9 8 7 6 5 4 % 9 8 7 6 5 4 capital that a financial institution should hold. many institutions chose to focus on asset growth. the larger the profit that must be generated in order for the target return to be met. a narrow definition of capital. A legacy of high equity and a lack of projects in which to invest it is frustrating. Whatever capital level is chosen. If banks make full use of allowable Tier Two capital this will provide them with the flexibility to reduce their capital holdings when the debt matures. Allocating Capital and Measuring Performance The focus of management in any organisation. against it must be set a target return. Perhaps institutions have a much better understanding of the risks they face and deem the regulatory requirement to be insufficient. Faced with this objective. as well as to the development of (some fairly sophisticated) capital allocation models and performance measurement frameworks. 7 3. the target return is driven by market expectations. regulatory requirements drive overall capital levels to some extent.

As would be expected given their similar names. It is important to give sufficient regard to the ubiquitous risk-return trade-off. comparing performance on the basis of return alone is like comparing apples with oranges in that it ignores the all too important influence of risk. Two of the most widespread risk-adjusted performance techniques are return on risk-adjusted capital (RORAC) and risk-adjusted return on capital (RAROC). in a dynamic capital allocation process the allocation of capital and the measurement of performance are necessarily inter-twined. until quite recently when comparing the performance of two business areas. In some institutions. Traditionally. while the RORAC measure adjusts the denominator (capital). In fact. it is extremely important that capital is allocated (and performance is measured) on an economic basis. banks would divide the return earned by each activity by the dollar amount of physical capital invested. In broad terms. To do otherwise would undermine the incentive for businesses to maximise return. discussed below. Clearly. the two techniques differ only slightly: although both use return on capital as a base. as opposed to a pro-rata one. Hence. these capital measures have not been adjusted for risk. A further stage in the process is the application of this imputed capital amount in a performance measurement context. a generic RAPM model would take the form: (return – expected loss) / amount at risk. or RAPM. Figure 3: A Dynamic Approach to Allocating Capital Determine capital available Measure return on capital and review performance Set target returns Allocate capital to businesses The term ‘risk-adjusted performance measure’. the return that is generated per unit of risk assumed should form the basis of the performance assessment. That aside. at the heart of all performance measurement frameworks. Many financial institutions have developed risk-adjusted performance measures to compare the performance of different activities with different economic capital requirements.) Of course. regardless of their complexity. The first stage of any capital allocation process is the derivation of an amount of capital attributable to the bank or to individual business units. Whatever method is chosen. rather than return alone. this description gives rise to two questions: how should the risk adjustment be made and what measure of risk should this adjustment be based on? The remainder of this section deals briefly with the first issue while Section 4 deals with the second issue. If individuals are to be remunerated on the basis of performance (ie on the basis of wise investment decisions). the sum total of the amount of capital allocated should never exceed the total amount of available capital – but it may be less. has become a widely used buzzword in the banking industry of late. The financial institution must define the methodology by which capital will be imputed to each business and then allocate the appropriate amount of capital to that business. Amongst other things.Chris Matten 8 investment of cash takes place. the RAROC measure adjusts the numerator (return) for risk. is a comparison of returns (such as profit or revenue) against some measure of capital. this requires that a direct link be established between return on capital measures and the performance-related remuneration of individuals within the institution. all RAPM techniques share the same underlying idea: return is compared against allocated capital by adopting some form of risk adjustment based on the institution’s assessment of the riskiness of the business that is undertaken. The capital allocation process can be driven by a number of methods. Of course. Although just about every institution that has toyed with these measures will offer a different description of their methodology. Expected losses typically cover expected credit losses that . the capital allocated to particular businesses might be adjusted to influence business results. high returns may simply result from investing in risky assets. by encouraging businesses to maximise returns on this allocated capital. As shown in Figure 3.

The term in the denominator. is usually defined as the capital necessary to cushion against unexpected credit losses. As highlighted earlier. and the cost of those defaults is a routine cost of doing business. operating risks and market risks. Almost immediately following the release of the credit risk standards in 1988.4 Note that expected losses are subtracted from revenues. Notwithstanding supervisors’ warnings. The basic approach taken in the Accord is to ‘risk weight’ an asset according to its riskiness. many of these shortcomings were well known when the credit standards were introduced. the core requirement of the Accord is that banks maintain a ratio of eligible capital to risk-weighted assets of at least 8 per cent. Claims on or secured by residential 4 5 6 See the paper by Funke Kupper in this Volume for further discussion of expected and unexpected losses. The incidence of defaults is part of the business of credit. Exposures to OECD governments. into on-balance sheet equivalents using conversion factors to capture the counterparty risk associated with such exposures. was still a step forward for many institutions. such as guarantees and derivatives. internationally active bank. it is acknowledged in the Accord itself that “the framework…is mainly directed towards…credit risk …but other risks…need to be taken into account”. and is often called risk capital or what was earlier referred to as economic capital. See Basel Committee on Banking Supervision (1988). Regulatory Models The 1988 Basel Accord provided supervisors with a framework for calculating what was generally considered to be the minimum amount of capital required for a well-diversified. all other exposures are assigned a risk weight of 100 per cent. many of the less sophisticated institutions adopted the regulatory model as their own credit risk measurement system. are deemed to be risk-free and consequently assigned a zero risk weight. as some measure of risk is incorporated into the assessment – some adjustment for risk is better than no adjustment. Claims on OECD banks are assigned a risk weight of 20 per cent. The regulatory model. The decision to limit the scope of the Accord was based on the importance of credit risk relative to other risks.1. with its simple regime of risk weights. work began on extending the capital rules to include a technique which captured the growing levels of market risk faced by institutions in their trading operations. in spite of its shortcomings. Regardless of the degree of sophistication of the performance technique used. The underlying principle was that institutions should hold a minimum level of capital that is somehow linked to the risks to which they are exposed. Risk Measurement Models 4. with other risks such as operational risk. In the first instance. Even using the simple risk weights of the regulatory framework as a base will produce superior returns to a strategy based on pure balance sheet amounts. the most obvious link was between capital and credit exposures. Interestingly. In contrast to the 9 4. the amount at risk. property usually attract a risk weight of 50 per cent and. at least not explicitly. the amount at risk is determined using one of the risk measurement models discussed below. As discussed below. Typically.Risk and Capital Management – An Overview cannot be regarded as ‘risk’. . the sensible allocation of capital must be superior to an approach that leaves this to chance. Supervisors had stressed repeatedly that the model was intended solely as a vehicle for calculating a regulatory capital charge and was not intended to replace institutions’ own risk measurement systems. expected defaults are confused with the real risks involved in the credit business (not adjusting for expected losses is like an insurance company taking in premiums and hoping that nobody ever makes a claim).6 On the much criticised coarseness of the risk weights: “there are inevitably some broad-brush judgements in deciding which risk weight should apply to different types of asset…”. The regulatory framework for measuring capital adequacy is criticised for its crude and unsophisticated nature. Techniques are also specified for converting off-balance sheet exposures. this illustrates the level of sophistication of credit risk models just a decade ago. In fact. At the very least. traded market risk5 and interest rate risk on the balance sheet not captured. as well as difficulties foreseen in developing a standard measure for some of these other risks. there was little evidence that more sophisticated approaches to the measurement of credit risk were being used by banks. for example. that diversification effects are ignored and that the focus on credit risk ignores many other important risks that institutions are exposed to. in general. in the years following its introduction the Accord was amended to take traded market risk into account. Other criticisms are that the risk weights are arbitrary and not based on empirical evidence. Commonly this step is forgotten. The example most commonly cited is the lack of differentiation between different kinds of private sector customer: a loan to a blue-chip multinational and a loan to the corner store carry the same risk weight (100 per cent).

the guidelines were relatively simple in structure. The basic approach taken required banks to separate exposures into a number of different risk classes (interest rate. the amount of capital to be held against these risks is some function of the potential loss to the institution caused by adverse changes in the value of its exposures (loans. or their own internal model. Fortunately the presence of traded markets for most instruments actually made the measurement task much simpler: given the availability of the requisite data. equities and. The market risk amendments to the Accord were issued in 1996 7 and offered institutions the choice of using either the standard method outlined in the initial proposals. Such calls for recognition are coming at a time when the shortcomings of the Accord are becoming increasingly evident. foreign exchange. together with supervisors’ acceptance of internal models for measuring market risk. based on the difficulty foreseen in valuing instruments such as the more exotic derivatives. Some of these have already been mentioned such as the limited number of risk categories (0 per cent. This was commented on. There were also concerns relating to the transparency and consistency of risk measures across institutions. commodities) and to multiply these exposures by pre-specified sensitivity factors. In all frameworks. models can be thought of as more complicated versions of the regulatory framework: instead of taking key parameters such as average price shifts as given. 1. as well as improvements in efficiency.Chris Matten 10 measurement of credit risk. later. with institutions using a single model for regulatory and internal purposes. in part. subject to supervisory approval. although standard parameters for confidence intervals and holding periods had not emerged. it was argued that a credible minimum standard could not exist if it was determined by institutions’ own assessments and that the industry’s capital levels would be less than desired from a systemic viewpoint. subject to determination by Basel of key parameters such as holding periods and confidence intervals. 4 per cent and 7 See Basel Committee on Banking Supervision (1996). In basic terms. statistical techniques are used to generate more accurate estimates. market risk largely becomes a quantitative matter. Before announcing their support for internal models. of the risks faced. Although considerably more complex than the credit proposals. This had the useful purpose of ensuring that the industry did not develop a consensus that the regulators could not accept. with some variations such as a proposal to capture separately commodity positions. and variously refined until an agreed upon standard emerged. Supervisors in favour of internal models argued that the benefits would include a greater awareness. These models were far more advanced than what supervisors were proposing and institutions argued that they should be allowed to use them to calculate the regulatory capital requirement. These proposals set forth an approach that was similar in many respects to the credit risk standards.6 per cent. It was eventually decided that institutions would be allowed to use their internal models to calculate a capital charge for market risk. .2. an iterative set of documents was produced. The rapid improvements that have been made in risk measurement techniques. trading positions etc). supervisors had already been in communication with institutions and had contributed to the debate about quantitative and qualitative standards to be adopted in the application of a VaR model. 4. by both banks and supervisors. have led many in the banking industry to propose that similar recognition be extended to internally developed credit risk models. Proposals for an additional market risk capital charge were issued by Basel in 1993. a view. where supervisors had achieved their objectives by adopting a relatively simplistic approach. Institutions had also been encouraged to use VaR before it was officially part of the regulatory capital framework. market risk was viewed by many as technically more difficult. A ‘best practice’ method was beginning to emerge. Against this. Internally Developed Credit Risk Models The risk measurement models developed by supervisors and institutions to assess credit and market risk share a common base (see Figure 4). by the time the market risk amendments were released many innovative institutions had already invested heavily in sophisticated risk measurement systems to allow them to manage their growing market risks. in the form of value-at-risk (VaR) models. Following Basel’s acceptance of internal models. This approach is central to the regulatory framework applied to credit risk and to institutions’ VaR models. In contrast to the generally primitive standard of the industry’s own credit risk measurement systems when the Accord was introduced in 1988. This was a ground-breaking proposal for supervisors and evoked considerable debate.

Like their market risk counterparts. and progress should be driven by much 11 Figure 4: The Similar Philosophies of Risk Measurement Models Book value of assets (plus off-balance sheet items converted to quasi-asset values) Risk weighting of assets (a measure of sensitivity to a change in value) A standard buffer against a change in value (8%) Basle Accord x x Market Risk Market value of exposures x Sensitivity of exposures to changes in underlying markets x Potential change in underlying markets Credit Risk Value of exposure to client at time of default x Likelihood of default and cost of default x Volatility of default factors . it is generally not possible to test the performance of the model using ‘out-of-sample’ data. the time to maturity. performance testing is also complex. The data availability issues make building and calibrating a model very difficult. is that credit-related instruments are not generally traded and there are few recorded default events. which is blessed with readily available data and supported by many academic studies. which must be modelled over time periods that span many years. of course. and inconsistencies between banking book and trading book treatment of similar instruments. much useful historical data has simply not been captured or stored. and associated probabilities. Before credit risk models will be accepted by regulators. such shortcomings can potentially lead to substantial differences between internally determined and regulatory capital charges. into a simplistic framework that offers little scope for recognising risk offsets. seniority ranking. there are a number of significant issues which the banking industry will need to resolve. with a particular emphasis placed on statistical techniques. as a result. The problem has not been helped by the fact that even within individual institutions. Ultimately. over a specified time horizon. To ensure adequate estimates of key credit risk model parameters. Unlike market risk. this is particularly difficult. Taken together. The data requirements for implementing a similar back-testing regime to that which exists for market risk may not be seen in this lifetime. such as default probabilities and correlations. such as credit derivatives.Risk and Capital Management – An Overview 8 per cent) and no recognition of portfolio effects. Finally. In particular. Despite the challenges that supervisors and institutions must confront in moving towards internal models. Part of the reason. there must be a sufficient store of data. Other shortcomings include difficulties in incorporating new instruments. The benefits of a models-based approach to credit risk are significant. the aim of all credit risk models is to estimate a distribution of potential credit losses. These primarily relate to data availability and model validation. would consider factors such as the riskiness of the counterparty and so the likelihood of default. collateral structure and correlations between exposures. Similarly. This distribution is then used to estimate the amount of capital that is required to bring the probability of unexpected losses exhausting this capital stock down to some targeted level. The result is the misstatement of a bank’s ‘true’ capital adequacy position and perverse business and risk management incentives. the severity of loss in the event of default. the time period over which credit risk manifests itself (years. there are some very good reasons for progressing. Many institutions have only recently begun warehousing the requisite data and it could be many years before there is enough to support a model adequately. internal credit risk models take a more sophisticated approach to risk measurement than does the regulatory framework. A typical credit risk model for example. credit risk is cursed with illiquid markets and a relative scarcity of data. This increased sophistication comes at the cost of extra time and expense in having to consider multiple variables related to individual exposures. estimation of the many parameters in a credit risk model consumes a good deal of data and. even whole economic cycles. In the case of credit risk. as opposed to days or even hours in the case of market risk) puts a practical limit on statistical modelling.

but that users put too much faith in them. The fact that the Basel Committee toyed with but then more or less backed away from this area is evidence of the devil which lies in the details. many financial institutions are already devoting significant resources to the measurement of interest rate risk on the balance sheet and operational risk. As a consequence. Accordingly. transparency in credit pricing will help to eliminate many of the hidden crosssubsidies that currently exist (and in an efficient markets context. but there is little consensus as to how to allocate capital against that risk. enhanced credit risk modelling techniques will lead to improved credit risk pricing methodologies. It is a positive signal that financial institutions are thinking more about the sorts of activities that they are willing to undertake. the formulation of a standard pricing methodology will encourage the development of a proper secondary market in debt. once a common model for credit risk has been agreed. the quality of controls and the experience of management (the sorts of issues that a rating agency will consider when assigning a rating). The problems with institutions such as Long-Term Capital Management and others is not that the models were not good enough. further levelling the playing field and encouraging competition. It is doubtful that this type of risk can be properly measured in a statistical way. as best practice will be rewarded with lower capital requirements. The situation at present is very similar to the pricing of options before the advent of the Black Scholes model. Conclusion The emergence of better risk and capital management techniques has been a big step forward for the industry. Institutions are also increasingly cognisant of the risks associated with various activities. Also. as all unwanted risks can be hedged away or sold into the market. The industry has formed a consensus on how to approach the issue. This will enable banks to concentrate on their customers. and operational risk – it is interesting to note that the Basel Committee has now turned its attention to operational risk. credit risk – this has already been discussed in some detail. and a lively market in credit derivatives. confidence intervals etc) and how to source data in a transparent. the focus of the industry . The following is a brief commentary of the state of play with regard to the modelling of some of the key risks faced by financial institutions: • market risk – there is obviously more to be learned. pricing will become easier and more widely understood. but there is no consensus yet on matters such as the parameters to use (holding periods. auditable and comparable way. since the kinds of events that do occur do not occur regularly enough.Chris Matten 12 bps 120 Figure 5: Mispricing of Credit Risk bps 120 RAROC price 100 80 60 Market price 40 20 0 Aaa Aa A Baa Ba B Caa 40 20 100 80 60 will shift to the measurement of other risks. the market will also become more transparent. interest rate risk on the balance sheet – there are a lot of tools available to manage the risks. hinder full economic development). a capital adequacy framework that more accurately reflects the actual risk profiles of institutions will be of benefit to all industry participants. For example. This will make the market safer. From a macroeconomic viewpoint. • 0 more than a desire to remove the anomalies from the present regulatory approach. many institutions are beginning to allocate 5. but the returns on the additional investment are diminishing rapidly. As well as being safer. Other Risks Looking to the future. An alternative approach (which may cover the even more nebulous business risk) might be to agree to some level of capital based on a subjective assessment of the kind of business undertaken. Figure 5 shows the typical disparities between risk-based prices and the actual prices observed in the market. Moreover. Indeed. • • 6.

all they say is that an institution cannot expect to lose more money than the model predicts more often than is predicted. to better align institutions’ risk profiles with the amounts of capital held. 13 7. The industry is currently at an important turning point in the development of risk measurement and capital allocation models. Ford (eds. Zaik. On the other hand. Do we continue down the path of models-based risk and capital management. ‘RAROC at Bank of America: From Theory to Practice’. ‘Amendment to the Capital Accord to Incorporate Market Risks’. Most importantly. and the controls around them. Managing Bank Capital: Capital Allocation and Performance Measurement. In this light. most importantly. ‘The Supervisory Treatment of Banks’ Market Risk’. Basel. The focus of the industry should be on the intelligent use of models. and one could envisage the adoption of a models-based approach for credit risk in the next five years or so. whilst continuing to develop risk management techniques and seek convergence of the regulatory model with industry best practice. and regulators. Matten. ‘International Convergence of Capital Measurement and Capital Standards’. G. but break down completely on the 1 per cent of occasions when you need them most”. On the one hand. T. . England. are aware of their shortcomings. the Basel Committee’s proposed reform of the entire capital adequacy framework. and C. in Readings in Financial Institution Management. in Readings in Financial Institution Management. (1996). J. face an uphill battle in keeping pace with new developments. Basel. Basel Committee on Banking Supervision (1996). John Wiley & Sons. This point was well captured by a quote in the press from a risk manager during the ERM crisis of 1993: “the models are fine 99 per cent of the time. and not an infallible oracle. it is paramount that institutions fully understand the models in place and. By improving the capital allocation process – even by simply realising the need for one in the first place – it is possible that the returns earned on that capital may improve. Kelling and C. Correspondingly.. is a step in the right direction. Walter. Gray. Cassidy (1999). James (1999). July. It must be remembered that even the best risk models will not stop an institution from losing money. which occur more often than most statistical models imply. T. or do we conclude from the recurrence of mistakes that such an approach has not worked and try something else? It is the contention of this paper that we do not have much of an option. Valentine and G. Allen & Unwin. Despite this challenge. January. there are numerous instances suggesting the apparent failure of risk measurement models to capture extreme events. If recent events are any guide (ie the Long-Term Capital Management problems) there is a very real risk that institutions are becoming too reliant on their models.Risk and Capital Management – An Overview capital on a risk-adjusted basis instead of relying on simplistic measures such as the return on assets or the return on the book value of equity.). Allen & Unwin. Australia. Australia. B. much progress has been made to standardise approaches and improve the precision of the regulatory approach. Ford (eds. J.). risk and capital management techniques are becoming increasingly complex and institutions. it needs to be remembered that a model is a tool. C. Valentine and G. References Basel Committee on Banking Supervision (1988).

that VaR models do not take liquidity into account. The events that are really important. First. perhaps. for that matter. This point is demonstrated by Figure 1. this is straightforward enough. the once-in-a-generation events. has significant implications for the usefulness of the risk measures generated by the models. that is. particularly international markets. when considering some of the innovative techniques being used to measure traded market risk. 1 per cent events do not give rise to significant concerns. To support this view. it could be argued that such events are normal everyday occurrences in financial market operations. particularly from regulators. I would like to expand on two of the ideas that have been put forward. namely: that VaR measures focus on 1 per cent events and provide limited insight into events that may threaten the solvency of financial institutions. Macquarie Bank. Allan Moss* Chris Matten’s paper provides an interesting overview of risk and capital management developments in the financial sector. In the life of a financial institution. the events that threaten the continued strength. It was not the one-day events that damaged the hedge * Managing Director. The above suggests that VaR measures should focus on more extreme events. Since many VaR models assume that financial market returns are normally distributed. In theory. That is. effectiveness and viability of financial institutions. Limitations of Risk Measurement Models Although value-at-risk (VaR) models are an enormous improvement on previous approaches to managing risk. the first part of the discussion considers some of the limitations of market risk measurement models. that 1 per cent events happen more than once in 100 days. Not only did hedge funds experience price moves that were bigger than 1 per cent events. a 1 per cent event. instead of choosing a 99 per cent confidence interval Figure 1: One-in-One-Hundred Events? SFE SPI Contract Absolute Values of Percentage Changes % 7 Actual move 6 5 4 3 2 1 0 9 Oct 15 Oct 21 Oct 27 Oct 31 Oct 6 Nov 99% move 6 5 4 3 2 1 0 % 7 The final point.99 per cent confidence interval. that is. Matten also makes reference to several incidences where financial institutions appear to be making the same errors time and time again. and that VaR ignores liquidity. and relationships between markets. say. Accordingly. will in all likelihood experience a 1 per cent event on approximately one day of each month. The recent hedge fund problems provide a useful example. a 99. (or a 1 per cent event). the choice of an extreme event or. a 1 per cent event may occur more than once in 100 days. In practice. the hedge funds’ problems stemmed from an inability to close out their positions. their true utility does not warrant the pre-eminence that they are now receiving. The reason is that most financial market returns are not distributed normally and instead follow a distribution that has fatter tails. . the paper acknowledges that models are a tool and not an oracle. The problem is that volatility within financial markets. are the one-in-ten-year events or. but they were unable to liquidate their losing positions.Discussion 14 1. I draw attention to three limitations of VaR models. In fact. This means that the likelihood of experiencing an extreme market move is actually much higher than the normal distribution would predict. the VaR measure should be based on. which shows a period in October 1997 where extreme moves were experienced every day for a week. is more complicated. What most affected the hedge funds was not an inability to measure the extent of their exposures at a given point in time. is unstable. all that is required is for the VaR measure to be based on a point further into the tail of the distribution. Financial institutions that participate in a number of markets. Rather. This point cannot be over-emphasised. The second part of the discussion offers a simple framework that perhaps provides insight into why institutions are not learning from their mistakes.

the shareholders and the regulatory agencies. In such a performance framework the ideal situation. and the bonuses paid. is to maximise the level of bonuses received. To analyse this phenomenon I would like to introduce the concept of the ‘rational manager’: a manager motivated purely by the incentives that apply to him or her as an individual. quite clearly. the total -40 amount of bonuses paid over the period is higher in this second payoff structure. and the net present value of profits is lower. however. particularly during the 1980s. The situation described above raises a couple of issues. these phenomena demonstrate that decisions that may be nonsensical from an institution’s perspective can. 10 10 5 0 1 2 3 4 5 6 Years 7 8 9 10 5 0 Figure 3: An Ideal Situation from the Rational Manager’s Perspective $'000 Profit 50 40 30 20 10 0 -10 -20 -30 Bonus 50 40 30 20 10 0 -10 -20 -30 -40 1 2 3 4 5 6 Years 7 8 9 10 $'000 The Bonus Phenomenon Consider a hypothetical institution that rewards each department with a bonus equivalent to 10 per cent of profits earned. in fact. while it is easy to see why an institution might prefer the outcome depicted in Figure 2. Figure 2: An Ideal Situation from an Institution’s Perspective $'000 Profit 25 Bonus 20 15 20 15 25 $'000 15 The ‘Rational Manager’ In recent years. the favourable performance is most probably being carried by the strong market position of the firm. Together. as opposed to any active decision making on the part of management. this type of reckless behaviour has been seen before. To . In the Figure. month-on-month effects of being forced to hold positions which were rapidly declining in value. and the phenomenon of managers with little to lose. Although the profits earned and bonuses paid exhibit a higher level of volatility. The problem is that. such as extending large loans to hedge funds and taking large derivative and emerging-market debt positions. the interests of an individual manager are not aligned with those of the institution. when the accuracy of the model really matters (ie in a crisis) the assumption of a reasonably liquid market may not hold. the profits generated by the department. be perfectly reasonable from the perspective of the individual. from the perspective of the Board. of course. often. the project finance phenomenon. the optimal payoff structure in this incentive system might look more like that portrayed in Figure 3. Why is it that financial institutions continue to make the same mistakes? I suggest that it is not the institutions that are making the mistakes but rather the managers within those institutions. The assumption that financial institutions will be able to exit their positions within a pre-specified holding period is a fundamental weakness of VaR models. might look something like that depicted in Figure 2. but rather the week-on-week. Three situations illustrate the potential for conflicts of interest between rational managers and financial institutions: the bonus phenomenon. financial institutions have made what appear to be absurd decisions.Risk and Capital Management – An Overview funds. As Matten observed. The ultimate objective of the manager. First. climb steadily from year to year. For the rational manager.

Nevertheless. However. Clearly. somewhat counterintuitive to the generally accepted belief that older people are more conservative. By contrast. there is a 77 per cent chance that the first five projects will be a success. If this period is not adequate. otherwise prudent managers often become less risk averse as the end of their career approaches. Given the discussion above. Assume that the typical manager will only complete ten projects in his or her career. it is highly likely that the rational manager will be willing to take on a project that is not in the institution’s best interests. There is also a very real chance that a manager will finish a career with a particular institution without experiencing a project failure. make sense from the perspective of the individual manager. this has not been the case. it is much more tempting for managers to base decisions in large projects on ambitious assumptions than it is in medium-sized projects since. it is because the level of bonuses paid can never be negative. Consider a middle manager who has fifteen years until retirement. That is. as was most probably the case in some of the recently announced write-offs from utility projects. If the outcomes of the projects are assumed to be independent. a business where the decisions of the individuals determine performance. there may also be an element of bad luck. that is. the law of averages is more likely to take effect and the manager must deal with the consequences. this level of risk is a significant concern. Hence. from the individual manager’s perspective it could be the case that the potential return generated by a given project is sufficient to warrant the associated risk. Of course. . The second. the project finance phenomenon. yet encourages management to make consistently ‘smart’ decisions. the risk of failure (ie the risk that the strategy will catch up with the manager) decreases at an increasing rate (see Figure 4). In my experience. this undermines the incentive framework that has been adopted. A lot of money was lost on office tower projects because the decisions to invest were based on all sorts of bold assumptions about future growth that did not hold. if an individual is playing with other people’s money it may be ‘rational’ to ‘bet big’. This suggests that what is required is a bonus system that is congruent with the earnings profile of the institution. the sharing of profits but not losses encourages excessive risk-taking and speculation. but the period of time over which the bonus is earned. The same projects. Further. the management of many financial institutions were nearing retirement. Although the risk analysis for a large project might appear to be more extensive. the results reported in Figure 3 reflect a ‘people business’. For the institution. At the time.Discussion 16 some extent. I think this is a phenomenon that is alive and well across a lot of different industries. in fact. related issue is why the performance framework for this hypothetical firm gives rise to conflicting ideals between the institution and its management. Hence. If a failure is predicted to be on the way. The Project Finance Phenomenon The second situation. as the manager approaches retirement. Perhaps the phenomenon of managers with little to lose underlined some of the problems experienced by Australian financial institutions during the late 1980s and early 1990s. applies to people who work on relatively large projects. Managers with Little to Lose The phenomenon of managers with little to lose is particularly relevant to top-level management. Not every project undertaken will be in the best interests of the firm. typically the assumptions underlying the recommendations are very heroic. there is always the option of moving to another institution. there is a 60 per cent chance that a particular manager will go through their entire career without experiencing a failed project. Assume there is a high-risk strategy that has a one in three chance of disaster in any given five-year period. such behaviour may. it would be ludicrous for such a manager to adopt this strategy since there is a 70 per cent chance that the strategy would not succeed. both in dollar terms and in terms of their career standing. Clearly. however. however. Understandably. The problem is not so much the concept of a bonus framework. A good example is the property experiences of the 1980s. may be in the best interests of management. Assume also that there is a 1 in 20 chance that a project will result in failure in the sense that the return realised by the project is less than expected. it would be expected that the risk analysis undertaken for a large project would be significantly more rigorous than that for medium-sized projects. Quite obviously. in the latter.

My third point is that a comprehensive understanding of risk should be a fundamental criterion for promotion. Supervisors should examine management incentive structures at all levels within the institution. where good character is defined as a sense of professionalism and commitment to the institution. This is because the more sophisticated manager is also more likely to achieve what should not be undertaken in the first place. some of the reasons that might explain the tendency of the finance industry to make the same mistakes. it is important for supervisors to be aware of new risks as these emerge and to recognise that the intensity of existing risks increases when commercial pressures rise. I believe that moving middle management around too much. Participants considered the issue of how to best structure incentive frameworks. through frequent restructures. management can continue as before. In many respects. It was argued that remuneration contracts could be structured such that . The alternative approach might be a high-risk strategy – dealing with hedge funds. Suppose the firm’s crisis management strategy is to adopt a conservative. 2. the ageing chairman played a key role in some very aggressive expansion policies. and contrary to popular wisdom. of bonus schemes. First. the shareholders of the institution are anxious. steady-as-it-goes approach where management ‘stick to what they know best’. There should be more attention focused on the impact on financial institutions of the one-in-ten-year events and the once-ina-generation events. and otherwise. Finally. perhaps including an equity component. there can be no trade-off between ability and good character. Consider a financial institution that is underperforming and takeover is imminent. nothing is lost because resignation was inevitable anyway. General Discussion Discussion explored three broad areas: the pros and cons of incentive frameworks. Moreover. Finally. From the perspective of the rational manager. is more likely to align the incentives of the individual and those of the firm than a series of one-off bonus payments. 17 it is well known that.Risk and Capital Management – An Overview Figure 4: Changes in Risk with Approaching Retirement % 70 Risk of disaster 60 50 40 30 20 10 0 15 14 13 12 11 10 9 8 7 6 5 4 3 Years to retirement 2 1 % 70 60 50 40 30 20 10 0 Summary What can be made of all this? For management and Boards I have a few suggestions. and the issues surrounding the use of models in the risk management process. a selfish manager with a lot of ability is more dangerous than a selfish manager with a standard level of ability. performance frameworks based on bonus payments are not necessarily detrimental to the institution – provided that the bonus scheme is appropriately structured. in at least one institution. A related phenomenon is the crisis phenomenon. rather than on the effect of 1 per cent events. under the former arrangement it is also far more likely that managers will be forced to deal with the consequences of their mistakes. Second. extending risky property loans and perhaps dabbling in investment banking. Again assume that there exists a 70 per cent chance that the strategy is successful. A large part of the discussion was spent exchanging ideas about the benefits. More consideration should also be given to the risk management skills of senior management. There has certainly been an element of ‘crisis behaviour’ within organisations over the past few years. A remuneration scheme based largely on deferred compensation. If it fails. Understandably. this is a desirable strategy. If the strategy works. I also have some advice for supervisors. is counterproductive in that it creates an environment where middle management does not have to manage the consequences of their poor decisions.

Management must hold firm to this approach and if some of the ‘stars’ refuse to work in such an environment then the institution must bear the cost of losing them – the risks of operating otherwise are too high. the trader is effectively paid to join an institution. with questions about executive bonus structures and other remuneration. Hence. For example. The second issue discussed related to the presence of ‘star traders’. once identified. While some of these managers are competent managers and appoint appropriately skilled people to work with them. accumulated bonuses on their departure. or by institutions with commercial banking backgrounds. In these instances. however it is less helpful if a framework already exists. the imminent court case. The authority to set limits. a particular institution might never have made these mistakes before. or at least many. Such arrangements are a particular concern owing to their potential to undermine prudential management and the longer-term incentives of the institution. to some extent the misjudgment might stem from a lack of experience. Again. such that the risk management performance framework and the incentive framework for the business units are equivalently structured. ‘Golden hellos’ were thought to be predominant in both the banking and the funds management industry. From a regulatory perspective. In some respects. he/she will demand payment by the new employer on the basis of a vested bonus. and was rewarded accordingly. exist. participating seriously in investment banking for the first time. those institutions did not have the historical experience to draw on. for example. this issue emphasises the potential flaws in the ‘universal manager’ concept. funds management firms and other trading institutions have experienced cases of former employees demanding. The general conclusion was that the risk management function in any institution should have more authority than business areas. the incentive framework is ineffective. with institutions and corporations of all forms implementing incentive structures. must be kept separate from the individuals that take day-to-day positions. Participants revisited the question raised in Matten’s presentation of why the industry continues to make the same mistakes. On a related issue. In either case. through legal representation. it was clear from the discussion that the bonus phenomenon has accelerated significantly over the past decade. Others were of the view that star traders were not a problem provided that ultimate control rests with more senior management. often results in the firm paying the employee if only to avoid the legal process. In any case. While the case against an employee might be quite strong. an institution that places equal or greater importance on risk management relative to income generation. If that trader generated favourable earnings in the previous year. Some participants were strongly of the view that the only way to overcome this problem was for institutions to demonstrate a willingness to see the legal process through to its completion. Of course. of the potential problem areas are eliminated. One explanation advanced in relation to wrong decisions in traded markets was that often the institutions encountering problems have little or no experience in the field – while the industry might make the same wrong decisions time and time again. many of the wellpublicised emerging market losses were incurred by relatively new institutions. there is a lot of value in understanding precisely the nature of the businesses in which the institution is involved. failure to acknowledge the extent of a problem might simply reflect a manager’s decision to turn a blind eye and . Specifically. will generally be well regarded. It was thought that regulators could perhaps play a role in evaluating the risks associated with the various incentive structures that institutions adopt. some participants highlighted the tendency for executive management to under-estimate the potential impact of particular problems. A competent risk manager should have the authority to take away a trader’s position. Additionally.Discussion 18 all. and a good deal of authority. It is quite often the case that a trader who is six months into the year and performing poorly against budget will begin searching for a new job in a competitive institution. some participants questioned the capacity of an institution to develop an incentive framework that achieves an appropriate balance between risk management and profit making when star traders that demand enormous bonuses and salaries. particularly for specialised segments of financial markets. it was felt this could be explained by the fact that in many cases individuals with commercial banking backgrounds are remarking on events in what are essentially traded markets. One participant noted that such an approach is relatively straightforward when implementing a new incentive framework.

it is often the case that when a major event occurs in a given market there are immediate flow-on effects to other markets. A commonly cited shortcoming of VaR models is that the data used to calibrate the models generally do 19 . for example. In a sense. the 1987 stockmarket crash created all sorts of disruptions in currency and commodity markets. it is also useful to have people with the relevant finance experience to ensure that the right questions are always asked. As identified in Matten’s presentation. should be on the extreme events in the tail of the portfolio loss distribution. Moreover. The focus. There was some discussion of whether or not stress limits should be additive. For this reason. one issue commonly raised in relation to risk measurement models is their implication that the past is necessarily a reliable guide to the future. improved risk measurement capability does not reduce the need for sound judgement and experience to be applied when evaluating risk. for example. be it banking. This perhaps contrasts with the Board membership of companies in other industries where widespread experience is highly valued. to the effective management and measurement of risk. of course. The issue of the effective implementation of risk measurement models was thought to be critical to the risk management process. With the rapid pace of development of risk measurement and capital allocation techniques in the financial services industry. The second level is a system of ‘stress limits’. These are based on the output of the institution’s value-at-risk (VaR) model and are ‘additive’ in that correlations between risk factors have been taken into account. It is important that such limits capture the inability to hedge or trade out of positions in the event that markets become illiquid. While it is straightforward to establish some stress events with the benefit of hindsight. That said. at the highest levels within financial institutions.Risk and Capital Management – An Overview hope that the problem will disappear because the consequences of the alternative are too grim. Being able to take a step back and assess the range of risks to which the institution is exposed and compare that assessment to the output generated by the models is an extremely important. There is always a risk that models may be applied somewhat blindly. executive management and the Board must accept ultimate responsibility for the risk management function within an institution. ‘crystal ball gazing’ needs to be undertaken to determine the types of extreme events that are likely to occur and the sorts of financial price movements associated with those events. and these models are religiously followed. insurance. task. no matter how comprehensive and welldocumented. All participants agreed that the development of rigorous analytical models to measure risk consistently across an institution is an invaluable component of the risk management process. While there is certainly a place for general experience on the Board of a financial institution. Discussion reiterated the point made in Matten’s presentation that even if an institution has in place the most sophisticated statistical models. Matten argued that at least these models force management to learn from the lessons of the past rather than forgetting the past altogether. The issue of the additivity of stress limits depends very much on how the scenarios are defined. particularly during periods when detailed risk evaluation and practical commonsense are most needed. What is does mean is that the institution will not lose any more money than the model predicts any more often than the model predicts. some participants felt that there is a lot of merit in the Board of a financial institution being comprised of a large proportion of non-executive directors from financial services backgrounds. While invariably there must be a certain amount of delegation. the very essence of scenario analysis is to assess the impact on earnings of very low-probability events. Certainly. stockbroking etc. will be ineffective unless it is consistently followed at all levels within the institution. but often difficult. the risk control framework generally operates on two levels. it is inevitable that many wellqualified non-executive directors will be struggling with many of the concepts. On the first level are the ‘risk limits’ that cover normal day-to-day trading. Most important in this regard is robust commitment. models are not the be all and end all of the risk management process. In the case of traded market risk. this does not mean that the institution will never experience a loss. the relationships between markets are not always predictable. This argument is used both by the model supporters and by those who reject the models altogether. Any risk management system. While it is unlikely that all extreme events are going to occur simultaneously. which capture the impact of extreme events on the earnings of the institution and reflect management expectations of potential large shifts in markets.

some participants felt that holding capital against the outcomes of ‘extreme event models’ would impose an enormous capital requirement on the industry. Inevitably there will be some institutions in the system that are not structurally sound and will never be able to cope with the once-in-a-generation events. For example. there is a lot of evidence that financial markets have more trend persistence than is implied by the normal distribution. It was argued that a judgement must be made as to how far into the tail of the distribution regulators should venture before the process becomes too burdensome for the industry.Discussion 20 not capture the once-in-a-generation events that institutions are concerned about. at least with the appropriate level of probability. The impact on the institution if all extreme events occur simultaneously is considered and capital is held to cover that impact. some large investment banks allocate capital on the basis of the results of scenario analysis. Other participants were of the view that banking institutions should be sufficiently capitalised to cover all extreme events. Additionally. While models can be developed that capture these phenomena. It is generally acknowledged that financial price distributions are fattailed. on which many VaR models are based. . One participant distinguished between ‘operational soundness’ for which reasonable amounts of capital are required and ‘structural soundness’ for which it is not feasible to expect ‘highly-leveraged’ institutions such as banks to hold capital.

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