Paradox: Adding Capital Increases Need for More Capital

The banking industry has a paradoxical problem. There is tremendous pressure to increase capital, but it can't increase capital by adding capital.

Over the last 25 years, while the risk that drives revenue models has changed fundamentally, the approach to dealing with extreme tail risk has changed only marginally, thus increasing the need for bigger shock-absorbing cushions. However, simply looking to increased capital without addressing the factors that drive this need is neither effective nor realistic.

If an institution adds capital then it needs to generate higher earnings to cover the cost of incremental capital. The quest for higher earnings requires taking on more risk to generate them from a revenue model driven primarily by risk management. In turn, higher risk creates the need for more capital. The paradox: adding capital increases the need for more capital. Therefore, increasing capital to maintain the current revenue engine is not effective.  

Given the high cost of capital, one can also question if the industry can realistically access the projected huge amount of capital in the near future. Therefore, something more fundamental must change. New solutions are needed, given the risk-management-driven nature of revenue models.

From an investor's perspective, there is another reason for a new approach. Studies show that meeting regulatory capital requirements is no assurance of the sustainability of institutions. Most failed banks weren't declared capital-deficient prior to their failure. This means what is critical isn't the compliance of capital ratios but how capital supports extreme tail risk. Tail risk refers to exposure from uncertainty that is so high that – if it materializes – it can turn into catastrophic losses and overwhelm institutions.

Also, one can conclude from these studies that the capital needed to protect against failures may be higher than the regulatory required ratio. So if banks have difficulty meeting the regulatory capital requirement currently, then it's nearly impossible to maintain higher requirements to ensure sustainability in extreme crises. Therefore, a different approach is needed.

There are two options to enhance institutional sustainability via capital: the supply option and the demand option. The current supply approach of focusing only on increasing capital is not really an effective option. The other approach of reducing demand on capital can make the current stock of capital go farther through focused actions and programs that preserve and protect capital.

Focusing on the demand option to enhance sustainability requires turning capital into the last defense against unexpected shocks. This would be a fundamental change from the current practice of employing capital as the first and the only defense against unexpected shocks. The difference may sound subtle, but has far-reaching implications.

The financial industry is the only major industry that employs capital as the first and the only defense against extreme tail risk. Some may argue with this statement.

Banks often mention the quality of earnings and management, effectiveness of the management process, etc., as the first defenses against unexpected losses, which is true. However, these intangibles don't provide the same measurable and objective protection as well-defined tangible programs. For example, no risk manager would recommend, nor would senior managers accept, an intangible like the quality of personnel or managers as a portfolio hedge instead of explicit tangible programs or limits that define controls.

So why should capital protection depend on intangibles? They are sound practices, and should be encouraged, but are no substitute for tangible defenses, leaving capital the first and only defense against extreme tail risk currently employed.

Because of the high cost, no other industry would think of using capital as the primary source of protection against unexpected shocks. Most industries go out of their way to implement specific risk-management and sustainability-management programs to protect capital. For example, nonfinancial companies provide elaborate sustainability programs (such as excess production capacity, business continuity plans and structured insurance programs) in addition to operating programs to protect capital against one of the largest risks — that of a major business interruption. The protective value of such programs is indicated by the fact that insurance companies, the last defense in front of capital, offer premium discounts for business interruption insurance if these protective programs are effectively implemented.

The desired effect is to provide a first defense against unexpected losses and turn capital into the last defense against extreme tail risk. Such programs have costs, and when triggered also involve large expenses, but these costs are far less than the alternative cost of capital as the first defense.

Deploying effectively and specifically protecting capital requires objectively defining and quantifying extreme tail risk. This can be done if approached methodically and proactively. But it requires viewing tail risk through a distinct prism with its own objective parameters for effective management to protect the institution from becoming a casualty in a crisis.

Such an approach would not only deploy capital more efficiently and enhance the sustainability of institutions but also strengthen the financial system.

Karamjeet Paul, managing principal of Strategic Exposure Group, is the author of "Managing Extreme Financial Risk: Strategies and Tactics for Going Concerns" (Academic Press, October 2013).