The estimations of expected risk and risk-based return of assets in our institu- tion’s portfolio, including combinations of different exposure factors, is one of
the basic tasks of enterprise risk management. Therefore, the solution that we adopt for internal control reasons should be able to provide dependable infor- mation along this frame of reference. The bottomline is that what we expect from stress testing is to:
● Reveal latent and hidden exposures associated to assets and liabilities, and
● Enhance, in the longer term, our institution’s financial staying power, in relation to risks that have been and continue being assumed.
These two points bring into our perspective the concepts of relative riskand rel- ative capital,which are a new development in enterprise risk management and, also, in banking supervision. Changes introduced in 2005 by the Basel Committee to the rules regarding capital adequacy through Basel II, practically align relativecapital requirements quite closely to relative risk. This strategy is significant for several reasons, the most important being that:
● It strengthens the soundness of financial institutions by making their cap- ital requirements dynamic, and
● It lessens some of the distortions that have arisen under the original 1988 Capital Accord and its fixed 8% capital ratio.
Risk management should capitalize on the fact that the concepts of relative cap- ital and relative risk, as well as of risk-based pricing, have entered financial dis- closure and supervisory review. As such, they are contributing to an earlier recognition of risk-related problems by markets, banks, and supervisors, essen- tially leading to faster and better focused corrective action.
Because they help an institution in being ahead of the curve, stress tests have an important role in connection to a dynamic approach to capital adequacy, guided by relative values. They can be effectively used to lead to worst-case scenarios in relative risk, and they can assist in prognosticating regulatory capital requirements through time – in line with the evolution of measured risk. Dynamic adjustments:
● Increase the bank’s staying power
● Prompt towards a more considered exposure, and
● Help in decreasing systemic risk in the financial system.
The degree to which such potential is realized depends on how closely meas- ured risktracks underlying risk. A high degree of accuracy is not easy to obtain through general rules, because each bank has its own characteristics. Therefore, every entity must establish its own modelling solution, though supervisory
guidelines help. As Chapter 14 brought to the reader’s attention, one of the options that has been applied is a regulatory approach which acts as a built-in stabilizer, limiting the procyclicalnature of the financial system. Spanish com- mercial banks are doing so, under directives by the Spanish central bank.
An alternative to relative capital matching relative risk is to require a provision to be created whenever the interest margin on a loan does not cover the expected losses arising from possible default. This can be based on the rating of a client firm plus a careful watch on credit volatility, assisted by the rating pattern estab- lished by independent rating agencies.
● What ifthe rating of a major counterparty changed from AA to A? to BBB?
to BB?
● What if25% or 50% of ourbank’s counterparties in the banking book and trading book moved downwards in credit rating?
● What if 5%, 10%, 15% of our counterparties defaulted? Where will this leave ourbanking book? Our trading book?
● Which emergency measures will be necessary? What kind of leading indi- cators should be used? From where will come the required capital reserves to weather the storm?
These are quite legitimate queries in the framework of an enterprise risk manage- ment system.9 The answers to be provided can be elaborated through scenario writing, and they must be most carefully thought out. While provisions might gen- erally not be required at origination of a loan or a derivatives trade, they might become subsequently necessary if the borrower’s credit quality deteriorates. This is an outcome of the dynamic nature of the market.
With this notion of synchronization between relative risk and relative capital, provisioning rules can be designed to act as the flywheel of the financial institu- tion’s survival course. Stress level can be thoroughly simulated. The drawback is that while today we have practically unlimited computing power,
● Our data sources are not well organized, and
● The information elements in our databases are often incomplete or obsolete.
Speaking from personal experience, it is highly recommended that a rigorous risk analysis looks at dataand its adequacy, as well as whether its form can be effectively exploited. Equally important is to be able to map the longer term pat- tern of counterparty dependability, including its leverage and the type of risks which this relationship involves. This issue will be more closely examined in
section 8, using as background detail from the virtual bankruptcy of Long Term Capital Management (LTCM).
LTCM treated money like a commodity. There is no objection to this approach, but at the same time it failed to apply adequate controls related to this commodity, its ups and downs and its risks. The information LTCM provided to its senior man- agement on assumed risk was dismal. There was nothing like a real-time balance sheet (see Chapter 15) to provide fingertip measures of liabilities versus assets.
By assuming an inordinate amount of risk, and at the same time being totally blind to worst-case scenarios connected to future market realities, and their impact on the company’s A&L, management can make all the wrong decisions. It can transform its operations into an abyss of exposure, just by doing the wrong things. While the LTCM partners had the feeling of being ‘active’, in reality their foremost activity was self-destruction.
● LTCM was a highly leveraged firm but its accounting was terrible.
● The management reporting structure was in shambles and the partners depended on phone calls to know what was going on in their own company.
This is indeed the best way to kill a firm, with leadership being reduced to the role played by a prima donna. Compare this to the many positive examples pre- sented in this book on real-time information technology, and fair value account- ing for all financial assets and liabilities. By marking to market and marking to model (provided the models are thoroughly tested), fair value can be evaluated intraday, and used not only in risk control but also in solving another current problem: the difficulty in forecasting distant events.
Provided a company is creditworthy and far-sighted, the use of longer horizons is most appropriate to raise capital, restructure the balance sheet, and take proac- tive risk management measures. This is another reason why in quantifying and qualifying credit risk and market risk through fair value, an institution is able to position itself against market forces, using objective capital requirements associ- ated with each risk class, and including projected frequency and likely impact of each risk event.