The linkage between internal capital measures and regulator capital requirements
Curiously, it’s a subject that doesn’t attract that much attention and there are many operational risk analysts I have met that actually don’t particularly distinguish between the two, even though they are quite different measures, reserves and methodologies as Ms Bies points out.
For safety and soundness reasons, bank supervisors must be sure that a bank with greater exposure to riskier lines of business, products and customers holds more capital than a bank that is more risk adverse and designs its business plan to minimise risk taking
Let me add a point about the differences between minimum regulator capital, as set out in the Basel accord and the level of capital that banks may choose to hold for business reasons
+ What is Capital in terms of risk
Before we look at the some of the gaps between these measures of risk and some of the misinterpretations that exist in the industry, let’s loosely define the terms. Capital, what is this? It is a term so often bantered around and hence becomes misused, perhaps even trendy to drop in conversation. In the context of banking and risk together it is a reserve that is held to preserve the “ongoing integrity” of the organisation, some people liken it to a buffer that ensures the institution can account for potential threats to its business and in this sense it provides protection against unexpected losses.
It generally comes in two forms Tier 1 and Tier 2, where Tier 1 is considered very safe, reliable and liquid and usually consists of common stock that is non-cumulative, irredeemable and retained earnings. Tier 2 is also accepted by global regulators as the second most reliable form of reserve and consists of accumulated after-tax surplus of captured earnings, revaluation reserves of fixed assets and long-term holdings of equity securities, hybrid dept/equity capital instruments and subordinated debt.
+Regulatory Capital vs Economic Capital
‘Regulatory Capital’ and ‘Economic Capital’ thus so far in our definition is the same thing however with regulatory capital the method in which to calculate the reserve is prescribed by the regulator, this ensures a greater comparability among banks and the Basel accord pillar II / III is specifically designed to facilitate this. Regulatory capital also defines what instruments can be used for Tier 1 and Tier 2 capital and, what risks the bank must measure, estimate and hold reserves for; the latter of that statement is all critical. By approaching operational risk from a regulatory capital perspective it is imperative for the bank to setup its event classifications so that it may integrate external data within its regulatory calculation.
Economic capital in comparison is a lot more dismembered because it encompasses risks that may not be directly part of the regulatory capital suite and ideally it would encourage the bank to include gearing of operations in the calculation. Economic Capital generally allows the bank to understand a profitability margin against associated or chosen risks and within each business line in turn. It is a metric often referred to in the theme of risk adjusted return on capital and it can be used to benchmark one business unit with another. Regulatory capital on the other hand is less focused on the business return and more on the bank describing its 99th percentile quartile of aggregated loss; a position it should have a complete aversion from and be holding reserves for.
While economic capital also enjoys the freedom of allowing the strategy of the framework to include calculation practices or remove them, this liberty often creates a major difference between the two methodologies. In particular, deriving regulatory capital from economic capital is a complex task, although many banks have taken to do both by bolting on reporting criteria for regulatory components within their economic capital systems. How this is done we will have to leave to another article as that is not what we are trying to drive out here. So back to Ms Bies, a statement she made left me pondering where the industry is truly at, well perhaps the outlook of some of those that operate in it.
One of the questions regulators have been asked as we work toward implementing Basel II is whether we can just continue to encourage the improvement in risk modeling at banks and stop there, I.E, Not tie risk models to capital.
I too have heard statements of similar tenor and was shocked, in fact every time I hear an operational risk analyst lean this way, one has this image of them traveling to a nine-to-five job with both fingers crossed; “please no BCP issues today”. They are generally well intentioned and following a check list but leaving the rest to go on luck.
In reality different banks don’t have the same risk and applying a blanket of audit check lists across the group doesn’t really assist senior management understand what causes their exposures. Most importantly focusing on the control cost effectiveness against risk in the light of products allows strategic decisions to be given a platform of justification. Then if we move back to our capital question surely risky business activities need higher reserves, not some smear across all organisations against a weird proxy such as “revenue”, that doesn’t present a real gauge to the type of risk a business entertains. For what it’s worth, I selected net profit as an example proxy because that is how the Basel II basic indicator approach operates and it has more critics than it does partisans.
Operational Risk in particular is nebulous, that is an auditor may follow a prescribed set of actions and still return an unsatisfactory result, quite simply because this risk classification is exogenous in nature and there are often many causes for a single fault, some of which no control can be 100% effective against. Quantifying operational risk from a capital perspective though is a solution to this unlikely problem because it ties probability, frequency and magnitude on the same curve and it is that curve that allows the analyst to best decide what the worse outcome may be and what should be reserved if such an event occurs.
So without further ado please find a link to the Bies speech here:
Bies on Capital
