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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

Loan defaults rise. 2.institutions have a memory span equivalent to that of a goldfish: apparently a goldfish’s memory span is so short that each revolution of the bowl is a completely new experience. perhaps even careless. and some thoughts on future developments in the area of risk measurement. is to provide creditor protection. This assertion is supported by the behaviour of many banks at different stages of the credit 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. changes in financial system lending tend to lag the economic cycle. This paper provides a broad overview of risk and capital management in financial intermediaries. the ideas underlying the concept of performance measurement are introduced and the techniques that banks use to allocate capital are briefly examined. and banks lose money and rein in lending. making the recession that they are so concerned about a foregone conclusion. Section 6 concludes with some consideration of the dangers in becoming too reliant on models. In Section 3.1 Dynamic provisioning forces institutions to acknowledge losses sooner with the consequence that. As Figure 1 shows. the role of capital in any company. institutions should be more ready to provide credit. when the economy turns upwards. Economic expansion causes banks to become optimistic. the increasing focus within the industry on dynamic provisioning will at least partially address this problem. Along comes a recession. Section 2 considers the role of capital in financial institutions Risk and Capital Management 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. be it a deposit-taking institution or a corporation. This requires that the company’s assets exceed . 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. Section 5 provides a brief overview of the state of play with regard to the measurement of other risks faced by financial institutions. Hopefully. Capital and Financial Institutions At the simplest level. often sparked by an official tightening in interest rates in response to precisely the easy credit which banks have been granting. The consequence of this is that banks do not extend credit at a time when the economy needs it most.

unidentified losses. the role of capital is to act as a buffer against future. Supervisors tightly restricted the activities banks were permitted to undertake. is discussed in detail in Section 4. proved very successful until the middle of the 1970s. This arrangement. suggests that a bank’s capital base should be sufficiently large to absorb even relatively unlikely events. ensured that banks could operate without fear of takeover or the fear of losing market share to outside entities. which was designed to ensure the stability of the financial system. For a bank. whilst leaving the institution able to operate at the same level of capacity. it cannot explain the relatively high levels of capital that banks hold. The result was somewhat predictable: an industry which was unaccustomed to competitive pressures suddenly became prone to excess. At this time. This framework. The consequent erosion of capital levels began to trouble supervisors. and the potential for contagion within the banking system. thereby protecting depositors. In many countries. . over lending to lowly-rated organisations in a bid to come out in front of the pack. 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. resulting from the collapse of the Bretton Woods exchange rate agreement. banks have been highly regulated. known as the 1988 Basel Accord2. For most of this century. While this simple rule is well established. put the relationship between supervisors and institutions under intense pressure. this tension led to a process of deregulation and the exposure of financial institutions to the cold winds of competition. but rather as part of the business itself. Ultimately. The only way to address the situation without increasing the competitive differences between countries was at the international level. as the prospect of large institutional failures loomed ever larger. The intermediation role played by banks.its liabilities such that the company is solvent. Hence. a common minimum framework was introduced across countries to determine appropriate capital levels on the basis of the riskiness of institutions’ assets. and highly protected. In return for this high degree of regulation.1. Strict control over the issue of banking licenses. entities. to do otherwise could undermine the soundness of the institution. these restrictions extended as far as dictating the interest rates that could be charged on customer deposits. the amount of capital held must cover both ‘normal’ or expected losses. Hence. banks were protected from competitive forces. a substantial increase in exchange rate and interest rate volatility. for example. as well as unexpected or improbable losses.

In short. 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. regulatory requirements drive overall capital levels to some extent. Perhaps institutions have a much better understanding of the risks they face and deem the regulatory requirement to be insufficient.While much criticism has been directed at the ‘crude’ nature of the 1988 Accord. banks’ capital ratios rose from the late 1980s to the middle of the 1990s (see Figure 2). Regulatory capital uses a two-tier concept. unrealised gains on investment securities and medium. While these trends may have reflected broader economic developments. In Australia.1). Capital ratios in a number of countries have certainly risen since the introduction of the Accord. ranging from the very narrow ‘equity plus stated reserves’ through to a measure that encompasses subordinated debt. A financial institution’s capital structure will be driven by a number of factors. The absolute amount of capital held will also depend on a range of factors. Tax considerations and regulatory requirements are obvious determinants. its success in both levelling the global playing field and improving the capital adequacy of banking systems around the world is undeniable. many different definitions of capital. ie shareholders’ equity. There are. Again. In general. many banks now hold capital significantly in excess of this regulatory long-term subordinated debt. a narrow definition of capital. while the second tier (Tier Two) includes items such as ‘hidden’ reserves. of course. There are numerous reasons put forward for why this might be the case.3 For most financial institutions. Figure 2 is based on regulatory capital. The first tier (Tier One) consists of share capital and disclosed reserves. Tier One capital must comprise at least 4 per cent of risk-weighted assets. is usually most appropriate. who are acting to maximise the return for shareholders. changes in regulatory requirements undoubtedly played a role in their emergence. A legacy of high equity and a lack of projects in which to invest it is frustrating. as specified in the Basel Accord. banks will use debt for at least a portion of their capital needs owing to its flexibility. Yet. 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. for example. there is no magic formula to determining the . 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.

appropriate amount of capital that a financial institution should hold. Instead. (This is distinct from the investment of physical capital. . The higher the amount of capital maintained. for example. the sum total of the amount of capital allocated should never exceed the total amount of available capital – but it may be less. many institutions chose to focus on asset growth. the target return is driven by market expectations. against it must be set a target return. Correspondingly. banks have two choices: either they can increase the amount of return per dollar of equity. as measured by the volume of assets on the balance sheet. as well as to the development of (some fairly sophisticated) capital allocation models and performance measurement frameworks. exceeding the market’s expectations will result in an increase in shareholder value. or they can decrease the amount of equity required per dollar of target return. 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. with the focus on the latter flowing from the need to increase return if the size of the balance sheet was to grow. Although not ‘rocket science’. 3. Whatever capital level is chosen. is the maximisation of the returns that shareholders receive on their equity investments. this has led to a much greater emphasis on capital management within financial institutions. in that no actual Risk and Capital Management – An Overview 8 investment of cash takes place. by return on equity and the creation of shareholder value. In turn. Faced with this objective. Allocating Capital and Measuring Performance The focus of management in any organisation. whereas failing to meet those expectations will result in a destruction of value. Of course. until recently this focus on return was surprisingly absent from the Boardrooms of most banks. Essentially. to a much larger degree. 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. the primary focus of many banks was on increasing the size of the institution. including financial institutions. The capital allocation process can be driven by a number of methods. 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). the larger the profit that must be generated in order for the target return to be met.) Of course. During the period of deregulation in the 1980s. management behaviour has tended to be driven. In more recent times.

the capital allocated to particular businesses might be adjusted to influence business results. In some institutions. 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. high returns may simply result from investing in risky assets. as opposed to a pro-rata one. this requires that a direct link be established between return on capital measures and the performance-related remuneration of individuals within the institution. Many financial institutions have developed risk- adjusted performance measures to compare the performance of different activities with different economic capital requirements. It is important to give sufficient regard to the ubiquitous risk-return trade-off. Clearly. Although just about every institution that has toyed with these measures will offer a different description of their methodology. A further stage in the process is the application of this imputed capital amount in a performance measurement context. In fact.discussed below. Of course. in a dynamic capital allocation process the allocation of capital and the measurement of performance are necessarily inter-twined. all RAPM techniques share the same underlying idea: return is compared against allocated capital by . rather than return alone. 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. 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. until quite recently when comparing the performance of two business areas. The term ‘risk-adjusted performance measure’. Hence. by encouraging businesses to maximise returns on this allocated capital. To do otherwise would undermine the incentive for businesses to maximise return. has become a widely used buzzword in the banking industry of late. banks would divide the return earned by each activity by the dollar amount of physical capital invested. at the heart of all performance measurement frameworks. the return that is generated per unit of risk assumed should form the basis of the performance assessment. Amongst other things. regardless of their complexity. Whatever method is chosen. these capital measures have not been adjusted for risk. is a comparison of returns (such as profit or revenue) against some measure of capital. or RAPM. If individuals are to be remunerated on the basis of performance (ie on the basis of wise investment decisions). it is extremely important that capital is allocated (and performance is measured) on an economic basis. Traditionally. As shown in Figure 3.

the amount at risk. is usually defined as the capital necessary to cushion against unexpected credit losses. a generic RAPM model would take the form: (return – expected loss) / amount at risk. Expected losses typically cover expected credit losses thatcannot be regarded as ‘risk’. and is often called risk capital or what was earlier referred to as economic capital. 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. 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). the two techniques differ only slightly: although both use return on capital as a base. Commonly this step is forgotten. That aside. and the cost of those defaults is a routine cost of doing business. as some measure of risk is incorporated into the assessment – some adjustment for risk is better than no adjustment. while the RORAC measure adjusts the denominator (capital). As would be expected given their similar names. . the amount at risk is determined using one of the risk measurement models discussed below. Regardless of the degree of sophistication of the performance technique used. operating risks and market risks. Typically. In broad terms. The incidence of defaults is part of the business of credit. The term in the denominator.4 Note that expected losses are subtracted from revenues. the RAROC measure adjusts the numerator (return) for risk. Two of the most widespread risk-adjusted performance techniques are return on risk-adjusted capital (RORAC) and risk-adjusted return on capital (RAROC). 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.adopting some form of risk adjustment based on the institution’s assessment of the riskiness of the business that is undertaken. the sensible allocation of capital must be superior to an approach that leaves this to chance.

such as guarantees and derivatives. many of these shortcomings were well known when the credit standards were introduced. As highlighted earlier. internationally active bank. traded market risk and interest rate risk on the balance sheet not captured. 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. for example.1. Claims on OECD banks are assigned a risk weight of 20 per cent. The regulatory framework for measuring capital adequacy is criticised for its crude and unsophisticated nature. The basic approach taken in the Accord is to ‘risk weight’ an asset according to its riskiness. are deemed to be risk-free and consequently assigned a zero risk weight. Claims on or secured by residential property usually attract a risk weight of 50 per cent and. as well as difficulties foreseen in developing a standard measure for some of these other risks. Other criticisms are that the risk weights are arbitrary and not based on empirical evidence. it is acknowledged in the Accord itself that “the framework…is mainly . 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). in general. The decision to limit the scope of the Accord was based on the importance of credit risk relative to other risks. Exposures to OECD governments. 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. 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. In fact. Interestingly. all other exposures are assigned a riskweight of 100 per cent. at least not explicitly. Risk Measurement Models 4. with other risks such as operational risk.4. In the first instance. into on-balance sheet equivalents using conversion factors to capture the counterparty risk associated with such exposures. Techniques are also specified for converting off- balance sheet exposures. the most obvious link was between capital and credit exposures. that diversification effects are ignored and that the focus on credit risk ignores many other important risks that institutions are exposed to.

there was little evidence that more sophisticated approaches to the measurement of credit risk were being used by banks. with its simple regime of risk weights.directed towards credit risk but other risks need to be taken into account”. Almost immediately following the release of the credit risk standards in 1988. commodities) and to multiply these exposures by pre-specified sensitivity factors. later. Although considerably more complex than the credit proposals. A ‘best practice’ method was beginning to emerge. At the very least. In contrast to the generally primitive standard of the industry’s own credit risk measurement systems when the Accord was introduced in 1988. in the form of value-at-risk (VaR) models. although . was still a step forward for many institutions. market risk largely becomes a quantitative matter. 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 part. Fortunately the presence of traded markets for most instruments actually made the measurement task much simpler: given the availability of the requisite data. In contrast to the Chris Matten 10 measurement of credit risk. equities and. foreign exchange. a view. based on the difficulty foreseen in valuing instruments such as the more exotic derivatives. 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. 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. this illustrates the level of sophistication of credit risk models just a decade ago. The regulatory model. the guidelines were relatively simple in structure. market risk was viewed by many as technically more difficult. The basic approach taken required banks to separate exposures into a number of different risk classes (interest rate. These proposals set forth an approach that was similar in many respects to the credit risk standards. 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”. where supervisors had achieved their objectives by adopting a relatively simplistic approach. Proposals for an additional market risk capital charge were issued by Basel in 1993. many of the less sophisticated institutions adopted the regulatory model as their own credit risk measurement system. Notwithstanding supervisors’ warnings. in spite of its shortcomings.

subject to determination by Basel of key parameters such as holding periods and confidence intervals. 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. It was eventually decided that institutions would be allowed to use their internal models to calculate a capital charge for market risk. This was a ground-breaking proposal for supervisors and evoked considerable debate. 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. 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. and variously refined until an agreed upon standard emerged. the amount of capital to be held against these risks is some function of the potential loss to the institution caused by .standard parameters for confidence intervals and holding periods had not emerged. Following Basel’s acceptance of internal models. with some variations such as a proposal to capture separately commodity positions. by both banks and supervisors. 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). of the risks faced. Against this. Institutions had also been encouraged to use VaR before it was officially part of the regulatory capital framework. an iterative set of documents was produced. In all frameworks.2. 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. This was commented on. as well as improvements in efficiency. There were also concerns relating to the transparency and consistency of risk measures across institutions. This had the useful purpose of ensuring that the industry did not develop a consensus that the regulators could not accept. or their own internal model. subject to supervisory approval. 4. Before announcing their support for internal models. Supervisors in favour of internal models argued that the benefits would include a greater awareness. with institutions using a single model for regulatory and internal purposes.

have led many in the banking industry to propose that similar recognition be extended to internally developed credit risk models. internal credit risk models take a more sophisticated approach to risk measurement than does the regulatory framework. 1. This approach is central to the regulatory framework applied to credit risk and to institutions’ VaR models. over a specified time horizon. seniority ranking. the time to maturity. Such calls for recognition are coming at a time when the shortcomings of the Accord are becoming increasingly evident. such shortcomings can potentially lead to substantial differences between internally determined and regulatory capital charges. In basic terms. would consider factors such as the riskiness of the counterparty and so the likelihood of default. Like their market risk counterparts. the severity of loss in the event of default. 4 per cent and 8 per cent) and no recognition of portfolio effects. statistical techniques are used to generate more accurate estimates. Some of these havealready been mentioned such as the limited number of risk categories (0 per cent. These primarily relate to data . and associated probabilities. 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. A typical credit risk model for example. The rapid improvements that have been made in risk measurement techniques. and inconsistencies between banking book and trading book treatment of similar instruments. Taken together. with a particular emphasis placed on statistical techniques.6 per cent. into a simplistic framework that offers little scope for recognising risk offsets. the aim of all credit risk models is to estimate a distribution of potential credit losses. trading positions etc). together with supervisors’ acceptance of internal models for measuring market risk. Ultimately. Other shortcomings include difficulties in incorporating new instruments. The result is the misstatement of a bank’s ‘true’ capital adequacy position and perverse business and risk management incentives. Before credit risk models will be accepted by regulators.adverse changes in the value of its exposures (loans. there are a number of significant issues which the banking industry will need to resolve. This increased sophistication comes at the cost of extra time and expense in having to consider multiple variables related to individual exposures. collateral structure and correlations between exposures. such as credit derivatives. 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.

there must be a sufficient store of data. Also. this is particularly difficult. The problem has not been helped by the fact that even within individual institutions. a capital adequacy framework that more accurately reflects the actual risk profiles of institutions will be of benefit to all industry participants. such as default probabilities and correlations. To ensure adequate estimates of key credit risk model parameters. of course. This will make the market safer. it is generally not possible to test the performance of the model using ‘out-of-sample’ data. As well as being safer. which is blessed with readily available data and supported by many academic studies. estimation of the many parameters in a credit risk model consumes a good deal of data and. which must be modelled over time periods that span many years. Unlike market risk. credit risk is cursed with illiquid markets and a relative scarcity of data. as best practice will be rewarded with lower capital requirements. is that credit-related instruments are not generally traded and there are few recorded default events. much useful historical data has simply not been captured or stored. even whole economic cycles. pricing will become easier and more widely understood. Figure 5 shows the typical disparities between risk-based prices and the actual prices .availability and model validation. The data requirements for implementing a similar back-testing regime to that which exists for market risk may not be seen in this lifetime. there are some very good reasons for progressing. the market will also become more transparent. as a result. Finally. For example. further levelling the playing field and encouraging competition. and progress should be driven by much more than a desire to remove the anomalies from the present regulatory approach. As a consequence. The data availability issues make building and calibrating a model very difficult. enhanced credit risk modelling techniques will lead to improved credit risk pricing methodologies. 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. the time period over which credit risk manifests itself (years. performance testing is also complex. as opposed to days or even hours in the case of market risk) puts a practical limit on statistical modelling. In the case of credit risk. Part of the reason. The benefits of a models- based approach to credit risk are significant. Similarly. In particular. Despite the challenges that supervisors and institutions must confront in moving towards internal models.

• interest rate risk on the balance sheet – there are a lot of tools available to manage the risks. but the returns on the additional investment are diminishing rapidly. Other Risks Looking to the future. but there is little consensus as to how to allocate capital against that risk. It is doubtful that this type of risk can be properly measured in a . and • operational risk – it is interesting to note that the Basel Committee has now turned its attention to operational risk. Moreover. many financial institutions are already devoting significant resources to the measurement of interest rate risk on the balance sheet and operational risk. but there is no consensus yet on matters such as the parameters to use (holding periods. as all unwanted risks can be hedged away or sold into the market. This will enable banks to concentrate on their customers. auditable and comparable way. 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. 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. the formulation of a standard pricing methodology will encourage the development of a proper secondary market in debt. The situation at present is very similar to the pricing of options before the advent of the Black Scholes model. hinder full economic development). confidence intervals etc) and how to source data in a transparent. • credit risk – this has already been discussed in some detail. Indeed. and a lively market in credit derivatives. but that users put too much faith in them.observed in the market. transparency in credit pricing will help to eliminate many of the hidden crosssubsidies that currently exist (and in an efficient markets context. 5. once a common model for credit risk has been agreed. From a macroeconomic viewpoint. The industry has formed a consensus on how to approach the issue. the focus of the industry will shift to the measurement of other risks. The problems with institutions such as Long-Term Capital Management and others is not that the models were not good enough.

It is a positive signal that financial institutions are thinking more about the sorts of activities that they are willing to undertake. since the kinds of events that do occur do not occur regularly enough. all they say is that an institution cannot expect to lose more money than the model predicts more often than is predicted. it is paramount that institutions fully understand the models in place and. risk and capital management techniques are becoming increasingly complex and institutions. which occur more often than most statistical models imply. face an uphill battle in keeping pace with new developments. It must be remembered that even the best risk models will not stop an institution from losing money. On the one hand. Institutions are also increasingly cognisant of the risks associated with various activities. much progress has been made to standardise approaches and improve the precision of the regulatory approach. and one could envisage the adoption of a models-based approach for credit risk in the next five years or so. The industry is currently at an important turning point in the development of risk measurement and capital allocation models. are aware of their shortcomings. many institutions are beginning to allocate capital on a risk-adjusted basis instead of relying on 13 simplistic measures such as the return on assets or the return on the book value of equity.statistical way. Conclusion The emergence of better risk and capital management techniques has been a big step forward for the industry. and regulators. 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. the quality of controls and the experience of management (the sorts of issues that a rating agency will consider when assigning a rating). 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. 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. This point was well captured by a quote in the press from a risk manager . Correspondingly. Despite this challenge. 6. Accordingly. On the other hand. most importantly.

J. Basel. in Readings in Financial Institution Management. Valentine and G.  Basel Committee on Banking Supervision (1996). ‘RAROC at Bank of America: From Theory to Practice’. July. Managing Bank Capital: Capital Allocation and Performance Measurement. the Basel Committee’s proposed reform of the entire capital adequacy framework. The focus of the industry should be on the intelligent use of models. 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. but break down completely on the 1 per cent of occasions when you need them most”. Cassidy (1999). Ford (eds.  Matten. T.). 7. Allen & Unwin. James (1999). Australia. England. Ford (eds. In this light. Bibliography  Risk and Capital Management by Chris Matten  Basel Committee on Banking Supervision (1988). in Readings in Financial Institution Management. Walter. (1996). John Wiley & Sons. Do we continue down the path of models-based risk and capital management. whilst continuing to develop risk management techniques and seek convergence of the regulatory model with industry best practice.. it needs to be remembered that a model is a tool. January. Most importantly. and not an infallible oracle.  Zaik. to better align institutions’ risk profiles with the amounts of capital held. C.). Australia. ‘The Supervisory Treatment of Banks’ Market Risk’. and the controls around them. Gray. ‘International Convergence of Capital Measurement and Capital Standards’. G. B. J. T. ‘Amendment to the Capital Accord to Incorporate  Market Risks’. Basel.during the ERM crisis of 1993: “the models are fine 99 per cent of the time. . Allen & Unwin. Kelling and C. Valentine and G. is a step in the right direction. and C.