On The Precipice of risk

The emergence of better risk-return and capital management techniques has

been a big step forward for the banking industry. It is a positive signal that

financial institutions are thinking more about which are the kinds of activities

that they are willing to undertake in this regard. Institutions are also now

increasingly cognizant of the risks, which are associated with various

activities. Accordingly, many institutions are beginning to allocate 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. By improving the

capital allocation process it is possible that the returns earned on that

capital might improve. Correspondingly, risk, return, and capital management

techniques are becoming increasingly complex with institutions and regulators

facing an uphill battle in keeping pace with new developments. In spite of this

challenge, it is paramount that institutions fully understand the models in

place and, most importantly, are able to use these in managing their business.

The industry is currently at an important turning point in the development of

risk-return measurement and capital allocation models. This has to do with the

fact that management behavior, in recent times, has tended to be driven, to a

much larger degree, by return on equity and the creation of shareholder value.

In turn, this has led to a much greater emphasis on capital management as well

as to the development of sophisticated profitability, risk and capital

allocation models in an integrated performance measurement framework.The focus

of management in any organization, including financial institutions, is the

maximization of the risk-adjusted returns that shareholders receive on their

equity investments. Faced with this objective, banks have two choices:

• They can increase the amount of return per rupee of equity, or
• They can decrease the amount of equity required per rupee of target
  
  return.

Essentially, the target return is driven by market expectations. Exceeding

the market’s expectations will result in an increase in shareholder value,

whereas failing to meet those expectations will result in a destruction of

value. Although not ‘rocket science’, until recently this focus on return

was surprisingly absent from the boardrooms of most banks.

Capital allocation



At the simplest level, the role of capital in any company is to provide

creditor protection. This requires that the company’s assets exceed its

liabilities such that the company is solvent. For a bank, the role of capital is

to act as a buffer against future unidentified losses, thereby protecting

depositors. Hence, the amount of capital held must cover both ‘normal’ or

expected losses, as well as unexpected or improbable losses, whilst leaving the

institution capable of operating at the same level of capacity.

While this simple rule is well established, determining the amount of capital

to set aside is complex. With the introduction of Basel II accord it will become

even more complex but provide substantial benefits as the accord deliberately

builds in rewards for stronger and more accurate risk measurement. In short,

there is no magic formula to determining the appropriate amount of capital that

a financial institution should hold. In a dynamic capital allocation process the

allocation of capital and the measurement of performance are necessarily

inter-twined. This requires that a direct link be established between return on

capital measures and the performance-related remuneration of individuals within

the institution. Hence, at the heart of all performance measurement frameworks,

regardless of their complexity, is a comparison of returns against some measure

of capital. Traditionally, these capital measures have not been adjusted for

risk. In fact, until quite recently when comparing the performance of two

business areas, banks would divide the return earned by each activity by the

rupee amount of physical capital invested. Of course, 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.

Risk-adjusted management



Clearly, high returns may simply result from investing in risky assets. If

individuals are to be remunerated on the basis of performance the return that is

generated per unit of risk assumed should form the basis of the performance

assessment, rather than return alone. It is important to give sufficient regard

to the term ‘risk adjusted performance management’, or RAPM, which has

become a widely used buzzword in the banking industry of late. Although there

are many different methodologies, 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 exposure in the business

that is undertaken. Regardless of the degree of sophistication of the

performance management technique used, the sensible allocation of capital must

be superior to an approach that leaves this to chance. Even using simple risk

weights of the regulatory framework as a base will produce superior returns to a

strategy based on balance sheet amounts, as some measure of risk is incorporated

into the assessment–some adjustment for risk is better than no adjustment.

Do you have the capability?



Before the RAPM framework can be implemented, financial institutions need to

resolve a number of significant issues. Today, data about the customer and the

customers business with the financial institution is fragmented into many

core-banking systems. The quality of the data is suspect, as many of the fields

are not used in the day-to-day customer sales/service activities. The problem

hasn’t been helped by the fact that even within institutions, useful data has

not been captured or stored. Many institutions have not begun warehousing the

requisite data in a repository that is designed to support the RAPM framework.

The future…



Looking ahead, once a performance management framework has been agreed upon,

the focus of the institutions can quickly shift to the capture of the

appropriate data and implementation of the appropriate models to measure and

manage all the different parts of the business. This is the ability to ‘slice

and dice’ cost and revenue by organization unit, branch, product and customer

and then allocate capital on a risk-adjusted basis to businesses that add value.

Indeed, many financial institutions are already doing this today with a

comprehensive suite of applications, data model to capture the detail data and

the technology.

Shekhar Dasgupta



The author is managing director of Oracle India.