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 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 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. In
Section 3, the ideas underlying the concept of performance measurement are introduced and
the techniques that banks use to allocate capital are briefly examined. 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. 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.

2. Capital and Financial Institutions

At the simplest level, the role of capital in any company, be it a deposit-taking institution or a
corporation, 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. While this simple
rule is well established, it cannot explain the relatively high levels of capital that banks hold.
The intermediation role played by banks, and the potential for contagion within the banking
system, suggests that a bank’s capital base should be sufficiently large to absorb even
relatively unlikely events; to do otherwise could undermine the soundness of the institution.
Hence, the amount of capital held must cover both ‘normal’ or expected losses, as well as
unexpected or improbable losses, whilst leaving the institution able to operate at the same
level of capacity. 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, but rather as part of the business itself.

For most of this century, banks have been highly regulated, and highly protected, entities.
Supervisors tightly restricted the activities banks were permitted to undertake. In many
countries, these restrictions extended as far as dictating the interest rates that could be
charged on customer deposits. In return for this high degree of regulation, banks were
protected from competitive forces. Strict control over the issue of banking licenses, for
example, ensured that banks could operate without fear of takeover or the fear of losing
market share to outside entities. This arrangement, which was designed to ensure the stability
of the financial system, proved very successful until the middle of the 1970s. At this time, a
substantial increase in exchange rate and interest rate volatility, resulting from the collapse of
the Bretton Woods exchange rate agreement, put the relationship between supervisors and
institutions under intense pressure. Ultimately, this tension led to a process of deregulation
and the exposure of financial institutions to the cold winds of competition.

The result was somewhat predictable: an industry which was unaccustomed to competitive
pressures suddenly became prone to excess, over lending to lowly-rated organisations in a bid
to come out in front of the pack. The consequent erosion of capital levels began to trouble
supervisors, as the prospect of large institutional failures loomed ever larger. The only way to
address the situation without increasing the competitive differences between countries was at
the international level. Hence, a common minimum framework was introduced across
countries to determine appropriate capital levels on the basis of the riskiness of institutions’
assets. This framework, known as the 1988 Basel Accord2, is discussed in detail in Section
4.1.
While much criticism has been directed at the ‘crude’ nature of the 1988 Accord, its success
in both levelling the global playing field and improving the capital adequacy of banking
systems around the world is undeniable. Capital ratios in a number of countries have certainly
risen since the introduction of the Accord. In Australia, for example, banks’ capital ratios
rose from the late 1980s to the middle of the 1990s (see Figure 2). While these trends may
have reflected broader economic developments, changes in regulatory requirements
undoubtedly played a role in their emergence.

There are, of course, many different definitions of capital, ranging from the very narrow
‘equity plus stated reserves’ through to a measure that encompasses subordinated debt. Figure
2 is based on regulatory capital, as specified in the Basel Accord. Regulatory capital uses a
two-tier concept. The first tier (Tier One) consists of share capital and disclosed reserves,
while the second tier (Tier Two) includes items such as ‘hidden’ reserves, unrealised gains on
investment securities and medium- to long-term subordinated debt.3 For most financial
institutions, who are acting to maximise the return for shareholders, a narrow definition of
capital, ie shareholders’ equity, is usually most appropriate.

A financial institution’s capital structure will be driven by a number of factors. Tax

considerations and regulatory requirements are obvious determinants. In general, banks will
use debt for at least a portion of their capital needs owing to its flexibility. A legacy of high
equity and a lack of projects in which to invest it is frustrating. 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. The absolute amount of capital held will also depend on a
range of factors. Again, regulatory requirements drive overall capital levels to some extent.
The Basel capital adequacy framework is founded on a minimum capital ratio of 8 per cent of
‘risk-weighted’ assets (as defined in Section 4.1). Tier One capital must comprise at least 4
per cent of risk-weighted assets.

Yet, many banks now hold capital significantly in excess of this regulatory minimum. There
are numerous reasons put forward for why this might be the case. Perhaps institutions have a
much better understanding of the risks they face and deem the regulatory requirement to be
insufficient. 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. In short, there is no magic formula to determining the
appropriate amount of capital that a financial institution should hold. Whatever capital level
is chosen, against it must be set a target return. The higher the amount of capital maintained,
the larger the profit that must be generated in order for the target return to be met.

3. Allocating Capital and Measuring Performance

The focus of management in any organisation, including financial institutions, is the

maximisation of the returns that shareholders receive on their equity investments. Faced with
this objective, banks have two choices: either they can increase the amount of return per
dollar of equity, or they can decrease the amount of equity required per dollar 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. Of course, 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.
Although not ‘rocket science’, until recently this focus on return was surprisingly absent from
the Boardrooms of most banks. Instead, many institutions chose to focus on asset growth.
During the period of deregulation in the 1980s, for example, the primary focus of many banks
was on increasing the size of the institution, as measured by the volume of assets on the
balance sheet. Correspondingly, 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), with
the focus on the latter flowing from the need to increase return if the size of the balance sheet
was to grow. In more recent times, management behaviour 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 within financial institutions, as well as to
the development of (some fairly sophisticated) capital allocation models and performance
measurement frameworks.

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. (This is
distinct from the investment of physical capital, in that no actual Risk and Capital
Management – An Overview 8 investment of cash takes place.) Of course, the sum total of
the amount of capital allocated should never exceed the total amount of available capital –
but it may be less. The capital allocation process can be driven by a number of methods,
discussed below. Whatever method is chosen, it is extremely important that capital is
allocated (and performance is measured) on an economic basis, as opposed to a pro-rata one.
To do otherwise would undermine the incentive for businesses to maximise return. 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.

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. In some institutions, the capital
allocated to particular businesses might be adjusted to influence business results, by
encouraging businesses to maximise returns on this allocated capital. A further stage in the
process is the application of this imputed capital amount in a performance measurement
context. Amongst other things, this requires that a direct link be established between return
on capital measures and the performance-related remuneration of individuals within the
institution. As shown in Figure 3, in a dynamic capital allocation process the allocation of
capital and the measurement of performance are necessarily inter-twined.

Hence, at the heart of all performance measurement frameworks, regardless of their

complexity, is a comparison of returns (such as profit or revenue) 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 dollar 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. Clearly, high returns may
simply result from investing in risky assets. If individuals are to be remunerated on the basis
of performance (ie on the basis of wise investment decisions), 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 ubiquitous risk-return trade-off.

The term ‘risk-adjusted performance measure’, or RAPM, has become a widely used
buzzword in the banking industry of late. Many financial institutions have developed risk-
adjusted performance measures to compare the performance of different activities with
different economic capital requirements. Although just about every institution that has toyed
with these measures will offer a different description of their methodology, 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. In broad terms, 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.

Two of the most widespread risk-adjusted performance techniques are return on risk-adjusted
capital (RORAC) and risk-adjusted return on capital (RAROC). As would be expected given
their similar names, the two techniques differ only slightly: although both use return on
capital as a base, the RAROC measure adjusts the numerator (return) for risk, while the
RORAC measure adjusts the denominator (capital). That aside, 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’.4 Note
that expected losses are subtracted from revenues. Commonly this step is forgotten; 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 incidence of defaults is part of the business of credit, and the cost of
those defaults is a routine cost of doing business. The term in the denominator, the amount at
risk, is usually defined as the capital necessary to cushion against unexpected credit losses,
operating risks and market risks, and is often called risk capital or what was earlier referred to
as economic capital. Typically, 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, the sensible
allocation of capital must be superior to an approach that leaves this to chance. 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, as some measure of risk is incorporated into
the assessment – some adjustment for risk is better than no adjustment.
4. Risk Measurement Models

4.1. 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,
internationally active bank. 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. In
the first instance, the most obvious link was between capital and credit exposures, with other
risks such as operational risk, traded market risk and interest rate risk on the balance sheet not
captured, at least not explicitly. The decision to limit the scope of the Accord was based on
the importance of credit risk relative to other risks, as well as difficulties foreseen in
developing a standard measure for some of these other risks.

The basic approach taken in the Accord is to ‘risk weight’ an asset according to its riskiness.
Exposures to OECD governments, for example, are deemed to be risk-free and consequently
assigned a zero risk weight. Claims on OECD banks are assigned a risk weight of 20 per cent.
Claims on or secured by residential property usually attract a risk weight of 50 per cent and,
in general, all other exposures are assigned a riskweight of 100 per cent. As highlighted
earlier, 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. Techniques are also specified for converting off-
balance sheet exposures, such as guarantees and derivatives, into on-balance sheet
equivalents using conversion factors to capture the counterparty risk associated with such
exposures.

The regulatory framework for measuring capital adequacy is criticised for its crude and
unsophisticated nature. 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). Other criticisms are that the
risk weights are arbitrary and not based on empirical evidence, that diversification effects are
ignored and that the focus on credit risk ignores many other important risks that institutions
are exposed to.
Interestingly, many of these shortcomings were well known when the credit standards were
introduced. In fact, 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”. 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”. 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. Notwithstanding supervisors’ warnings, many of the less sophisticated institutions
adopted the regulatory model as their own credit risk measurement system. The regulatory
model, with its simple regime of risk weights, was still a step forward for many institutions,
in spite of its shortcomings. At the very least, this illustrates the level of sophistication of
credit risk models just a decade ago; there was little evidence that more sophisticated
approaches to the measurement of credit risk were being used by banks.

Almost immediately following the release of the credit risk standards in 1988, 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 contrast to the Chris Matten 10
measurement of credit risk, where supervisors had achieved their objectives by adopting a
relatively simplistic approach, market risk was viewed by many as technically more difficult;
a view, in part, based on the difficulty foreseen in valuing instruments such as the more
exotic derivatives. Fortunately the presence of traded markets for most instruments actually
made the measurement task much simpler: given the availability of the requisite data, market
risk largely becomes a quantitative matter.

Proposals for an additional market risk capital charge were issued by Basel in 1993. These
proposals set forth an approach that was similar in many respects to the credit risk standards.
Although considerably more complex than the credit proposals, 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, foreign exchange, equities and, later,
commodities) and to multiply these exposures by pre-specified sensitivity factors.

In contrast to the generally primitive standard of the industry’s own credit risk measurement
systems when the Accord was introduced in 1988, 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. A ‘best practice’
method was beginning to emerge, in the form of value-at-risk (VaR) models, although
standard parameters for confidence intervals and holding periods had not emerged. 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.

This was a ground-breaking proposal for supervisors and evoked considerable debate.
Supervisors in favour of internal models argued that the benefits would include a greater
awareness, by both banks and supervisors, of the risks faced, as well as improvements in
efficiency, with institutions using a single model for regulatory and internal purposes.
Against this, 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. There were also concerns relating to the
transparency and consistency of risk measures across institutions.

It was eventually decided that institutions would be allowed to use their internal models to
calculate a capital charge for market risk, subject to determination by Basel of key parameters
such as holding periods and confidence intervals. Before announcing their support for
internal models, 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. This had the useful purpose of ensuring that the industry did not
develop a consensus that the regulators could not accept. Institutions had also been
encouraged to use VaR before it was officially part of the regulatory capital framework.
Following Basel’s acceptance of internal models, an iterative set of documents was produced.
This was commented on, and variously refined until an agreed upon standard emerged. 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, with some
variations such as a proposal to capture separately commodity positions, or their own internal
model, subject to supervisory approval.

4.2. 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). In all frameworks, 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, trading positions etc). This approach is
central to the regulatory framework applied to credit risk and to institutions’ VaR models. In
basic terms, 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, statistical
techniques are used to generate more accurate estimates.

The rapid improvements that have been made in risk measurement techniques, together with
supervisors’ acceptance of internal models for measuring market risk, have led many in the
banking industry to propose that similar recognition be extended to internally developed
credit risk models. Such calls for recognition are coming at a time when the shortcomings of
the Accord are becoming increasingly evident. Some of these havealready been mentioned
such as the limited number of risk categories (0 per cent, 1.6 per cent, 4 per cent and 8 per
cent) and no recognition of portfolio effects. Other shortcomings include difficulties in
incorporating new instruments, such as credit derivatives, into a simplistic framework that
offers little scope for recognising risk offsets, and inconsistencies between banking book and
trading book treatment of similar instruments. Taken together, such shortcomings can
potentially lead to substantial differences between internally determined and regulatory
capital charges. The result is the misstatement of a bank’s ‘true’ capital adequacy position
and perverse business and risk management incentives.

Like their market risk counterparts, internal credit risk models take a more sophisticated
approach to risk measurement than does the regulatory framework, with a particular emphasis
placed on statistical techniques. This increased sophistication comes at the cost of extra time
and expense in having to consider multiple variables related to individual exposures. A
typical credit risk model for example, would consider factors such as the riskiness of the
counterparty and so the likelihood of default, the severity of loss in the event of default, the
time to maturity, seniority ranking, collateral structure and correlations between exposures.
Ultimately, the aim of all credit risk models is to estimate a distribution of potential credit
losses, and associated probabilities, over a specified time horizon. 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.

Before credit risk models will be accepted by regulators, there are a number of significant
issues which the banking industry will need to resolve. These primarily relate to data
availability and model validation. To ensure adequate estimates of key credit risk model
parameters, such as default probabilities and correlations, there must be a sufficient store of
data. In the case of credit risk, which must be modelled over time periods that span many
years, even whole economic cycles, this is particularly difficult. Unlike market risk, which is
blessed with readily available data and supported by many academic studies, credit risk is
cursed with illiquid markets and a relative scarcity of data. Part of the reason, of course, is
that credit-related instruments are not generally traded and there are few recorded default
events. The problem has not been helped by the fact that even within individual institutions,
much useful historical data has simply not been captured or stored. 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. Finally, the time period over which credit risk
manifests itself (years, as opposed to days or even hours in the case of market risk) puts a
practical limit on statistical modelling.

The data availability issues make building and calibrating a model very difficult. Similarly,
performance testing is also complex. In particular, estimation of the many parameters in a
credit risk model consumes a good deal of data and, as a result, it is generally not possible to
test the performance of the model using ‘out-of-sample’ data. The data requirements for
implementing a similar back-testing regime to that which exists for market risk may not be
seen in this lifetime.

Despite the challenges that supervisors and institutions must confront in moving towards
internal models, there are some very good reasons for progressing. The benefits of a models-
based approach to credit risk are significant, and progress should be driven by much more
than a desire to remove the anomalies from the present regulatory approach. For example, a
capital adequacy framework that more accurately reflects the actual risk profiles of
institutions will be of benefit to all industry participants, as best practice will be rewarded
with lower capital requirements. This will make the market safer. As well as being safer, the
market will also become more transparent, further levelling the playing field and encouraging
competition.

Also, enhanced credit risk modelling techniques will lead to improved credit risk pricing
methodologies. As a consequence, pricing will become easier and more widely understood.
Figure 5 shows the typical disparities between risk-based prices and the actual prices
observed in the market. The situation at present is very similar to the pricing of options
before the advent of the Black Scholes model. From a macroeconomic viewpoint,
transparency in credit pricing will help to eliminate many of the hidden crosssubsidies that
currently exist (and in an efficient markets context, hinder full economic development).
Moreover, the formulation of a standard pricing methodology will encourage the
development of a proper secondary market in debt, and a lively market in credit derivatives.
This will enable banks to concentrate on their customers, as all unwanted risks can be hedged
away or sold into the market.

5. Other Risks

Looking to the future, once a common model for credit risk has been agreed, the focus of the
industry will shift to the measurement of other risks. Indeed, many financial institutions are
already devoting significant resources to the measurement of interest rate risk on the balance
sheet and operational risk. 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, but the returns on the additional
investment are diminishing rapidly. The problems with institutions such as Long-Term
Capital Management and others is not that the models were not good enough, but that users
put too much faith in them;

• interest rate risk on the balance sheet – there are a lot of tools available to manage the risks,
but there is little consensus as to how to allocate capital against that risk. 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;

• credit risk – this has already been discussed in some detail. The industry has formed a
consensus on how to approach the issue, but there is no consensus yet on matters such as the
parameters to use (holding periods, confidence intervals etc) and how to source data in a
transparent, auditable and comparable way; and

• operational risk – it is interesting to note that the Basel Committee has now turned its
attention to operational risk. It is doubtful that this type of risk can be properly measured in a
statistical way, since the kinds of events that do occur do not occur regularly enough. 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, the quality of controls and the experience of management (the sorts of issues that
a rating agency will consider when assigning a rating).

6. Conclusion

The emergence of better risk and capital management techniques has been a big step forward
for the industry. It is a positive signal that financial institutions are thinking more about the
sorts of activities that they are willing to undertake. Institutions are also increasingly
cognisant of the risks associated with various activities. Accordingly, 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. 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.

Correspondingly, risk and capital management techniques are becoming increasingly

complex and institutions, and regulators, face an uphill battle in keeping pace with new
developments. Despite this challenge, it is paramount that institutions fully understand the
models in place and, most importantly, are aware of their shortcomings. 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. It must be remembered that even the
best risk models will not stop an institution from losing money; all they say is that an
institution cannot expect to lose more money than the model predicts more often than is
predicted.

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

measurement and capital allocation models. On the one hand, 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. On the other hand, there are numerous instances suggesting the apparent failure of risk
measurement models to capture extreme events, which occur more often than most statistical
models imply. 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, but break down
completely on the 1 per cent of occasions when you need them most”. Most importantly, it
needs to be remembered that a model is a tool, and not an infallible oracle.

Do we continue down the path of models-based risk and capital management, 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. The
focus of the industry should be on the intelligent use of models, and the controls around them,
whilst continuing to develop risk management techniques and seek convergence of the
regulatory model with industry best practice. In this light, the Basel Committee’s proposed
reform of the entire capital adequacy framework, to better align institutions’ risk profiles with
the amounts of capital held, is a step in the right direction.

7. Bibliography

 Risk and Capital Management by Chris Matten

 Basel Committee on Banking Supervision (1988), ‘International Convergence of
Capital Measurement and Capital Standards’, Basel, July.

 Basel Committee on Banking Supervision (1996), ‘Amendment to the Capital Accord

to Incorporate

 Market Risks’, Basel, January. Gray, B. and C. Cassidy (1999), ‘The Supervisory
Treatment of Banks’ Market Risk’, in Readings in Financial Institution Management,
T. Valentine and G. Ford (eds.), Allen & Unwin, Australia.

 Matten, C. (1996), Managing Bank Capital: Capital Allocation and Performance

Measurement, John Wiley & Sons, England.

 Zaik, J., J. Walter, G. Kelling and C. James (1999), ‘RAROC at Bank of America:
From Theory to Practice’, in Readings in Financial Institution Management, T.
Valentine and G. Ford (eds.), Allen & Unwin, Australia.