Risk Management and Value Creation in ... - Arabictrader.com

206 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
that are not (necessarily) under the control of the bank. Such external
factors include the intensity of competition in the market and the
effect of the economic cycle on the customer base. 339 Additional
revenue volatility may also stem from the bank’s products moving
through their life cycle.
2. Second, business risk tends to grow proportionally to a bank’s fixed
cost base, that is, the larger the fixed cost base, the higher will be the
need for business risk capital. While this assumption does not hold
for all banks and/or business units, the fixed cost base tends to be
the most predictive driver of the amount of business risk capital.
3. The last of the three key drivers is the volatility (or rigidity) of variable
costs. Here we are concerned with the unexpected fluctuations
in variable costs that are not direct responses to the variations in
revenues. These unexpected fluctuations are caused by rigid variable
costs that do not change in a timely fashion and that cannot be
reduced even by strict cost management.
The sum of the fixed cost base (2.) plus the rigid variable costs (3.) form
the threshold level (labeled in Figure 5.10 above as “fixed” costs) from which
the bank needs to hold economic capital. 340
There are basically two approaches to derive the required amount of
economic capital for business risk.
Historical Accounting-Based Approach After defining the level at which granular
historical revenue and cost time series can be obtained, 341 the (cleaned 342 )
historic data series 343 need to be adjusted. We need to remove the gains and
losses of trading 344 and credit 345 activities, 346 as well as adjust for any extraordinary
items 347 before we can estimate the expected value and the
339 These factors are, therefore, also considered in the agency ratings process.
340 Consistent to the other approaches, the bank only needs to hold economic capital
for business risk up to a certain confidence level.
341 This assumes that all costs are correctly allocated at the chosen level of reporting.
342 For outliers, and so on.
343 To adjust the data for the impact of the economic cycle and the bank’s general
(expected) growth, we need to obtain as long a time series as possible—at least over
the last economic cycle.
344 Including treasury activities, assuming that they are correctly transfer priced to
the business units.
345 Including transfer risk and any default-related losses.
346 See Wills et al. (1999), p. 94.
347 We need to adjust for changes in the internal accounting conventions and any
other general structural or reporting inconsistencies.