“From capital adequacy to capital optimization (2nd of 2 parts)” by Christian G. Lauron (March 26, 2012)
SUITS THE C-SUITE By Christian G. Lauron
Business World (03/26/2012)
In last week’s article, we introduced certain global guidelines (Basel III) and local developments (Monetary Board and the Bangko Sentral ng Pilipinas) regarding capital, liquidity and governance. We will now look into strategic forecasting as an effective tool in capital optimization.
STRATEGIC FORECASTING, CAPITAL OPTIMIZATION
This convergence is probably a CEO’s delight — it sets the disciplined and rigorous basis for capital allocation, particularly when capital has become “more expensive” as opposed to “scarce” (there may be a nuance to catch — the shift to taking “profitable risks” from a capital raising ethos). From 2012 to 2015, boards and management will likely analyze and implement capital optimization opportunities through the following routes:
• Business modeling and change in risk-taking activities;
• Risk-weighted assets (RWA) optimization through enhancements in methodologies, reporting and infrastructure; and,
• Long-term scenario planning.
Given increased capital (and soon liquidity) requirements, the immediate impact is that some businesses and initiatives may become less viable and there will be more reallocation of capital to businesses and initiatives that have the potential to offer better and sustainable risk-adjusted returns.
In this article, we will focus on the enabling processes rather than the quality and creativity of scenarios and strategies. One such process is strategic forecasting that can provide robustness to scenarios and business models.
Under current strategic planning models, forecasts (or budgets) are developed through the high-level projection of assets and RWAs implied by organizational rules of thumb, which may be just as heuristic as history-reinforcing (e.g., cost-to-income ratio and growth). Often these forecasts (or budgets) are viewed from a business line perspective only and the monitoring focus is on profit-and-loss target versus projection, again by business lines, and tends to overlook the impact on balance sheet related costs and constraints. In some cases, no funding and liability modeling is undertaken (even though a general transfer pricing mechanism is applied, but purely as a notional budgeting exercise). Further, assumptions like valuation and provisions are developed from a largely finance perspective.
Capital optimization from the business line view can be readily achieved in strategic forecasting by pursuing some refining or calibration initiatives. One initiative is to push strategic forecasting at the business line level or clusters of business lines bound “virtually” by a strategic initiative that takes a product or customer focus.
Companies can consider this as a complementary, or even a nimbler alternative, to an organizational redesign. In applying this, management needs to deal with three significant hurdles: first is to embrace a matrix-type of reporting (for the strategic initiative) and balance this with the administrative line reporting (for the existing business line); second is to deal with incremental performance targets and results in the case of strategic initiatives; and third is to work with the “transfer-pricing” costs (which traditionally pertain to cost of funds) but from a full-cost view (which will now take overhead costs, capital and liquidity charges).
However, we are not advocating a full transfer pricing. Such a push down could exact a heavy toll in terms of diminished cooperation or collaboration among business lines. Business lines can instead look at a consolidated yet strategic view which leads to another initiative: Develop a strategic balance sheet that combines the statutory and business line forecasts. The absence of such a combined view could lead to a scenario where the profitability of the business lines (and strategic initiatives) is wiped out by legal entity costs such as overhead, liquidity and capital charges.
Enhancements in data quality, systems and methodologies can also lead to what we call RWA optimization — the key first step towards economic capital optimization. Its business objective is to ensure that capital requirement calculations are efficient and risk-sensitive, which would enable the integration of risk and finance in the forecasting process.
For example, in estimating capital usage and provisions, business lines tend to use standardized capital calculations and accounting estimates that are backward looking and not dynamic. Business lines would have a tighter view by employing risk-sensitive capital calculations mapped to the projected credit quality of their targets (e.g., internal ratings-based calculations) and expected loss measures.
Furthermore, RWA optimization could allow the freeing up of capital buffers that are right now locked in standardized approaches. There is a strong case, for example, in operational risk, where the current the Basic Indicator Approach masks potential capital savings that are intuitively present for an organization with business-operations alignment and a fully functioning risk management and control framework. Such freed-up capital could be used to “offset” additional capital charges in other risk categories and future capital buffers.
A word of caution, though: RWA optimization should be part of an integrative, connected and holistic approach. Such an approach would include the strengthening of the following organizational initiatives:
• Use of overlay approaches in applying judgment over the economic and risk capital charge determination. The overlays are:
» Treasury and Assets and Liabilities Management (ALM) (to cover market, interest rate and liquidity);
» credit, counterparty and concentration;
» operational, compliance and reputation; and,
» strategic and business.
• A macroeconomic modeling component of integrated stress testing (the other components being capital sensitivity scenario analysis and risk sensitivity stress testing). This component is key for the capital conservation and countercyclical capital buffers and should incorporate transmission risk assessment and monitoring.
• Full economic capital modeling that integrates corporate and business strategy, financial planning and risk management.
Organizations must embark on full RWA optimization analyses alongside capital planning (and capital raising, if warranted from the corporate and business side). It is prudent to assign any freed-up capital from RWA optimization to additional capital buffer requirements — no expectation should be made about “business capital savings” that can be redeployed elsewhere.
Also, without meaning to preempt any supervisory guidance, organizations can build a case against an automatic industry-wide imposition of the additional capital buffer requirements as long as banks make proportionate investments in integrated stress testing, make this a governance agenda, and submit to a periodic network or system-wide stress testing program that has a commonly-drawn up interrelationship map of prudential, monetary, and fiscal risk indicators.
The initiatives we have described are achievable within 2012 to 2015 and already have some traction, given that with the ICAAP exercise, banks have taken a granular look at their three- to five-year business plans and are looking at “embedding in business use” the strategic forecasting process. There is definitely no substitute for a thorough reinvigoration of strategic forecasting that is eventually linked to the governance tool of scenario planning.
In scenario planning, we dealt primarily with “mental models” as part of the operationalization of the process at the board governance level. In strategic forecasting, management deals primarily with the interaction of the languages of risk and finance to induce capital optimization. It would be interesting to study how this interaction can be influenced by a silent game-changer: IFRS.
Christian G. Lauron is a partner of SGV & Co.
This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.