net income simulation as a basis for measuring risk exposure? As the Federal Reserve noted in a recent study, from 1982 to 1992, 1,442 U.S. banking institutions have failed. One can assume that most of these banks sought to measure risk through some form of net income simulation. The same is true for many of the savings and loan associations that used that method as their primary risk management tool in the late 1970s. The fact that these institutions failed is a clear indication that relying on net income alone to capture true risk exposure is a dangerous practice. Many bankers may argue that the purpose of net income simulation is solely limited to the measurement of the effect of interest rate fluctuation on net income and is not meant to capture credit risk, which is the true culprit of the banking industry's crisis in the late 1980s and early 1990s. It is clear that net interest income simulation wasn't enough to save the savings institutions that relied so heavily on this measurement. By analyzing the impact of credit risk variables and interest rate movement using mark-to-market valuation techniques, bankers are able to measure risk exposure in a much more comprehensive manner. In analyzing the merits of a market-based risk measurement system, it is constructive to examine how investment fund managers measure the same types of financial risks that banks face. From the standpoint of balance sheet composition, asset management companies are very similar, if not identical, to banking institutions. With limited exceptions, there is nothing that a bank has on the asset side of its balance sheet that cannot be found in the investment portfolio of a large fixed-income fund manager in the United States. For example, fixed-income fund managers invest in the same types of securities: *U.S. Treasury securities. *Eurodollar deposits. *Reserve repos. *Credit card receivables. *Mortgage-backed securities. *And collateralized mortgage obligations. From the perspective of asset composition, therefore, it is not unreasonable to say the fund manager is a bank. This also holds true on the liability side of a fund manager's balance sheet: Liabilities are composed of a large number of small retail "deposits." The objective of the fund manager is to invest these deposits to maximize returns to "shareholders," which in the case of a fund management company is the equivalent to the fund's "depositors," or investors. Although the balance sheet composition of banks and fund managers bear striking resemblance, all similarities cease when examining how these two types of financial institutions measure their asset and liability risk exposure. In the fund management business, net income simulation, often considered the core risk management tool employed by banks, does not exist. Rather, fund managers measure risk exposure one way only: mark-to-market valuation. Consider how differently a fund manager operates without this influence: *Risk limits: The fund manager seeks to match the risk of a specific base portfolio, often labeled as an index such as the Lehman Brothers U.S. Treasury index, which includes all outstanding U.S. Treasury issues. *Communication of the risk limit to investors: The fund manager clearly identifies for investors the name of the index by which risk is measured. *Performance measurement: Good performance is defined as a total return in excess of the index, without taking risk in excess of the risk embedded in the portfolio of investments that define the index. After all, if management can't exceed the results of a "naive" strategy like holding a certain percentage of all Treasury bonds, shareholders of the fund will not be willing to pay a management fee. We believe that if simulating the net income volatility of fund manager's investment portfolios would improve risk-return performance, it would be employed as a standard measurement. In no case, however, do fund managers use the measurement of net income to manage their risk exposure. Why don't fund managers use net income simulation? There are many reasons. First, shareholders care about total return, not just dividend yield, and net income simulation in both the fund management business and the bank business measures only the "dividend yield" of the business and ignores the capital gains. Second, net income simulation is almost always done for a time horizon that is too short to capture full interest rate risk: even a three-year time horizon, much longer than most banks use, is too short to have saved most of the S&L industry that was lending at a fixed rate for 30 years while borrowing short term. Third, net income simulation doesn't provide guidance on simple derivatives transactions that seemingly improve net income, but do not enhance shareholder value. A mark-to-market approach makes it clear why there is no value in receiving a fixed rate on a five-year swap and paying a fixed rate on a three-year swap, even though net income increases for the first three years in an upward sloping yield curve environment. There are also a number of reasons why banks continue to rely so heavily on net income simulation as a risk management tool: *Bank management has historically communicated both risk and return to the investment community in the form of a communication about net income. *The compensation system for branch managers is best structured on the basis of financial accounting based on the total return of the branch "portfolio." Net income is easier to understand and administer. *Banks have historically had trouble accurately estimating the market value of large portions of their assets (e.g., commercial loans) and liabilities (e.g., nonmaturity demand deposits). The first two factors indicate that net-income-based risk measures will continue to play a residual role at commercial banks for the foreseeable future. Mark-to-market risk measures, however, are well positioned to take over the dominant measurement role in risk management, now that mark-to-market calculations are feasible for the entire on-balance-sheet and off-balance- sheet holdings of commercial banks. This shift to mark-to-market valuation as a basis for risk measurement is clearly supported by the federal banking agencies in their recent proposal regarding interest rate risk and risk-based capital measurement. In the agencies' latest proposal, net income as a measurement of risk has been completely supplanted by a focus on "economic value," which provides "a more comprehensive measure of risk than measures which focus solely on the exposure to a bank's near-term earnings," the agencies state. In a recent consulting assignment for a major U.S. regional bank, we worked with the financial staff of the bank to demonstrate to senior management that interest rate movements and a simple credit index could explain 94% of the monthly stock price movement over a five-year period. We further validated the market's view by comparing the mark-to-market value of liabilities with the stock market's view of bank value. We found a very high correlation between the actual market value (stock price times number of shares outstanding) and the mark-to-market value of the balance sheet. Armed with two historical views of market value, we were able to demonstrate to management a full stress test of the balance sheet for a very wide range of interest rate scenarios that were fully compatible with actual movements in the bank's stock.
