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Regulatory Capital, Models, and Holistic Balance Sheet Management

Regulatory

Regulatory Capital,Models, and HolisticBalance Sheet ManagementBy taking a holistic approach to balance sheetmanagement, you can see beyond the hype of currentrules and model-based approaches. This article detailsthe principles of such an approach as well as the stepsyou can take to effectively manage complex balancesheet risks.b y Dav i d M. Ro w e a n d Th o m a s DayBa n k i n g a n d f i n a n c e practitioners realize that risk,particularly its management, is a difficult topic. By itsvery nature, risk describes that which is unknown buthas the potential to occur. And risk management isabout trying to understand, explore, and mitigate unknownbut potential exposures.Perhaps as a response to risk’s unfathomable qualities,modern risk management portrays itself as a scientificexercise in prediction and forecasting. But itis not always so. Although specialized and complexmodels can be valuable tools for converting a disconnectedmass of data into actionable information, theyare simply one part of a wider process of risk managementthat is as much art as science.Recent market upheavals have emphasized onceagain that models—their implementation, specification,calibration, and parameterization—are mereapproximations, not “realities.” Moreover, gratuitouscomplexity can result in “black box” risk, in which thelack of model transparency becomes a risk factor.Today’s crisis environment also emphasizes how riskmodeling and risk management tend to focus on onetype of risk at a time when reality is much more complex.Although some risk models try to account for allrisk types (credit, market, price, interest rate, liquidity,operational, etc.), the practical reality is that many risks,especially complex, interconnected risks, border on theunknowable in a data- and model-driven context.Thankfully, we aren’t limited to data and models, butare able to use imagination and good judgment to thinkthrough business models and risk connections in a moreholistic way. This article has three simple aims:1. To highlight why a holistic approach to balance sheetmanagement is necessary.2. To describe how current rules and model-based approachesfall short—and why they always will.3. To propose several pragmatic steps to see beyondthe hype and into the harsh reality of what it takesto effectively manage complex balance sheet risks.What Is “Holistic” Balance Sheet Management?At the risk of introducing new slang into the riskmanagement lexicon, it is important to differentiate“enterprise risk management” (ERM) from “holistic”balance sheet management. Some would have youbelieve that ERM is a model- or vendor-based platformsolution. Rather, ERM is a governance functionthat starts with the board of directors, not models orThe RMA Journal February 2008 51

packaged software. There is no “easy button” for effectiveenterprise risk management. Nevertheless, sound ERMfor a bank or other financial institution does include aholistic approach to balance sheet risk assessment.Such an approach recognizes, first, that all risk is“derived.” That is, risk is a derivative impact originatingfrom some “source.” In the case of a balancesheet, risk is derived from cash flows, contingent andotherwise, and how those cash flows react to changingand evolving market factors. Serious—potentiallycatastrophic—risk is generally not transactional; it isthe result of risk pools and concentrations with linkagesacross the balance sheet that are often obscure atbest. For example:• Credit risk and operational risk: Was a loss the resultof credit risk or the result of an operational lapse thatfailed to perfect the bank’s security interest?• Reputational risk and funding liquidity risk: Will a regulatoryfine cause a funding problem for the bank?• Interest rate and default risk: Will rising reset rates onindexed ARMs cause a dangerous jump in paymentdefaults?Many risk linkages are far more subtle and complexthan the above examples. Given that most models aretargeted toward specific risk types—credit, interest rate,price, liquidity, structure, correlation, volatility—it becomesclear that integrating across these risks requiresmore than models; it requires improved governance,processes, principles, and, perhaps above all, imagination.Holistic balance sheet management accepts thismandate.Such active balance sheet risk management meanstaking a unified view across all risk types at the consolidated,or enterprise, level. This reaches beyond BaselII, wherein risk quantification is limited to credit, operational,and market risk and in which even standardasset/liability management for the banking book is relegatedto Pillar 2. It is also an approach based more onprinciples and expert judgment than on simple fixedparametermodels, such as the asymptotic single-factorcredit risk model embedded in Pillar 1 of Basel II.To effect good balance sheet management, one groupmust be given a mandate—backed by senior managementsupport—for active identification, measurement,assessment, and management of balance sheet risks.Perhaps ironically, this risk management activity maynot be performed by the bank’s risk management function.Why? Too many “risk management” groups areconsidered cost centers, just “compliance” functionserected to appease regulators, stockholders, and ratingagencies. Such risk groups document what businessunits do, but they don’t actually manage risk. Theirability to influence the business is severely limited.One risk practitioner described his role as a “glorifiedscribe.” In the words of former Citibank Chief ExecutiveJohn S. Reed:“Everyone in banking points to risk managementas a top priority, but that is often just lip service.Risk analysis can easily become a series of routinechores that offer little protection from theunexpected.” 1The existence of such groups is not necessarily abad thing. In highly regulated and privileged industriessuch as banking, where a public trust is at stake,there is a legitimate role for an independent group thatmonitors risk-taking business activity. Calling such activityrisk “management,” however, is misleading; risk“policing” would be a better term. There must be anothergroup that isn’t merely a cost center or a strictlycompliance function.This group is the balance sheet management function,and it should be expected to add—as well as protect—value.The job of such a group goes several stepsbeyond today’s traditionally staid ALM and Treasurypractices. It undertakes active management of holisticbalance sheet exposures across risk types. The aim ofthis division is to maximize earnings potential of thebalance sheet while being highly cognizant of where,why, and how risk is stored—including contingentand off-balance-sheet exposures.Moving in this direction often involves couplingeconomic capital, portfolio credit, and ALM groups, or,minimally, creating collaboration forums across thesegroups to produce a more holistic perspective on thebalance sheet. More often than not, such combining orcollaborating rapidly leads to better risk-based pricing,capital management, concentration monitoring, andlimits and discretionary activity to hedge, transform,or reduce oversized exposures. Holistic balance sheetmanagement—when done right—is exploratory andrelies as much on good judgment, expertise, and wisdomas on models and portfolio risk methodologies.Some might ask, “But isn’t this precisely what Basel IIis aiming to accomplish?”How Current Rules and Model-Based ApproachesFall ShortBasel II is an excellent, rules-based document. Much ofthe philosophy behind Basel II can be traced to value-atriskmodels used for trading-book risk assessment thatevolved in the early to mid-1990s. The credit portfoliomodel used in Pillar 1 of Basel II is a default-modemodel with fixed, albeit conservative, parameters. 2 Butconservative in exactly what sense? It’s conservative onthe basis of its measurement goal—credit risk—and theparameters resulting from calibration for expected and52February 2008 The RMA Journal

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