Resilience planning for the financial sector

By Christian G. Lauron and Michael Angelo B. Dela Cruz

First Published in Business World (11/4/ 2013)

IN OUR Financial Regulatory Reform series published between April and June this year, we discussed the rapidly-evolving regulatory landscape and the three strategic themes that pose challenges for the financial sector, supervisors and policy-makers. These are:

• Reforming (or refreshing) business models in an uncertain environment;

• Formulating “accept and adapt” strategies for an industry under siege; and

• Preparing for industry consolidation and structural reforms.

We identified three responses to help frame the issues and coordinate strategies: strategic balance sheet management; resilience planning at institutional and system-wide levels; and incorporating industry consolidation and regional integration into strategic planning.

We will now focus on resilience planning as our response to the “new” macro-prudential thinking, which currently governs financial stability and capital standards. Resilience planning operates on two levels — institutional and sector-wide.

REDESIGNING AN INSTITUTION’S RESILIENCE MECHANISM

This conceptually involves integrating strategic planning, stress testing, and recovery and resolution planning (“living wills”). Based on our high-level view on the current state of the financial sector, the first step is to strengthen and redesign three areas: Risk Modeling, Strategic Assessment and Risk Governance, and the Capital Planning Engine.

Risk Modeling. This pertains to rigorous bottom-up risk assessments covering the Pillar 1 risks (market, credit and operational) and Pillar 2 risks (to cover the expanded areas of interest rate risk in the banking book, liquidity, compliance, reputational, and strategic) as well as macro and emerging risks (e.g., transmission and country risks). These risk assessments are supported by modeling and models with varying levels of sophistication and granularity, ranging from modified standard measures to “at-risk” and expected shortfall measures.

While risk modeling tends to be complex because portfolios and classes of transactions are involved, it need not be complicated if the choice of modeling technique is driven by business needs, particularly by the need to precisely measure risk appetite and know the balance sheet costs of capital and funding.

Quantitative analysts and modelers may aspire for a single model that will measure all risks and capture idiosyncrasies, but achieving this would be a Pyrrhic victory as it would subject the institution to high model risk. Philosophically, institutions may simply have to accept the incompleteness of models and the asymptotic nature of risks. In practice, this could mean hosting satellite risk models linked to a risk-based capital planning engine. These risk models, in turn, are further subjected to the three filters of aggregation, concentration and correlation reviews. For good measure, independent and holistic validations of these models should be conducted at least annually.

To encompass both the assessment and measurement processes, risk modeling should be supported by an enterprise-wide risk management platform, which is a key area of concern under Pillar 2 of Basel III. Without such an enabling platform, risk modeling becomes disconnected from the risk-taking activities of the institution.

This area surfaces the risk management issues that are used to develop worst-case stress scenarios, and which become inputs to the Stress Testing exercise in the Capital Planning Engine.

Strategic Assessment and Risk Governance. This area produces the business-as-usual stress scenarios that are used to tighten the implementation of the institution’s strategic plan, which may coincide with the quarterly business reviews. It also addresses the link between risk-taking to the institution’s business models and strategic goals. There are two broad sets of activities:

• Conduct of risk self-assessments designed to identify the key business issues of the board and senior management; and

• Reflecting the business models and strategies in the institution’s risk appetite, risk profile, and risk capacity.

Capital Planning Engine. This houses the integrated stress testing process and reflects the internal risk-based view of capital, funding and liquidity. It covers both the worst-case stress scenarios (which are inputs of risk modeling) and business-as-usual stress scenarios (which are inputs of strategic risk assessment and risk governance).

The worst-case stress scenarios are fed into the periodic stress testing that ranges from the rapid portfolio tests to the annual stress testing exercise, and it has links to the supervisory-led uniform stress testing.

The tightening process under the business-as-usual stress scenarios is governed by a constraint objective — a simplified example is the optimization of current and forecasted return on equity (ROE), capital adequacy ratio (CAR), common equity tier 1 (CET1), and risk-adjusted return on capital (RAROC).

The internal risk-based picture comes from an integrated analysis of the institution’s current and projected balance sheet. The increasing costs of capital and the negative carry associated with buffers and reserves are pushing financial institutions to look inward by refreshing their strategies and revising business models. The reinvigorated tools include the strategic balance sheet, strategic funding plan and asset-liability management.

The resilience architecture we have described follows a going-concern ethos. This means that even with the incorporation of worst-case stress scenarios, there is still an implicit assumption that the institution will continue to operate. Under the “living wills” regime, the incorporation of a “gone-concern” paradigm would mean an institution should also be prepared for exit scenarios. This means having a rigorous plan to facilitate the resolution or winding up of the institution in a controlled manner, with minimum public or taxpayer cost and systemic disruption. Financial institutions should consider making “living wills” a board discussion agenda, and appreciating the implications of macro-prudential regulation on the financial sector as a whole.

REVISITING THE FINANCIAL SECTOR’S RESILIENCE MECHANISM

At the system-wide level, resilience planning could serve as an integrated policy tool for evaluating the probability and severity of stress for the financial system. It can also establish the resilience of the financial sector in enabling the growth agenda of the real economy. Adopting this tool would help manage unintended policy impositions, like system-wide capital charges (e.g., countercyclical capital buffers) where more calibrated responses are needed, particularly where the systemic risk is driven by more idiosyncratic reasons (e.g., disproportionate risk-taking of a few players).

This systems-wide tool should contain three decision panels that the financial sector as a whole should undertake as a joint effort:

• Comparative mapping and point-in-time system-wide stress testing of the financial institutions’ resilience indicators (may be limited to CAR, CET1 and Risk Assets);

• Financial sector flow and balance that simulate and diagnose the banking sector’s systemic strength or risk, domestic-foreign financing mix and level of credit leverage (measured quickly as bank credit assets over GDP); and

• Transmission risk analysis between the banking sector and the financial markets — through feedback analysis and risk interactions between the banking sector and the sovereign — and between the financial sector as a whole and the real economy. The transmission channel between the financial sector and the real economy is driven mainly by monetary and fiscal policies, the government’s growth direction, the level and quality of public investments for private sector development (or “public goods”), and depth, commitment and pacing on structural reforms.

These tools can provide useful insights on policy questions, especially as the growth agenda shifts to the real economy, notably on the eve of ASEAN economic integration and with the wave of bilateral and multilateral free trade agreements. It is our hope that using these resilience tools can help settle the regulatory reform conundrum and move all strategic and policy agenda into an accelerated growth mode. After all, resilience sits on a precipice. When not properly optimized or exploited, resilience can easily result in stagnation.

Christian G. Lauron is a partner of SGV & Co. Michael Angelo B. Dela Cruz is a director 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.