Financial institutions can realize the full potential of economic capital as a planning tool to fulfill shareholder wealth if they are savvy in applying it, according to a new PricewaterhouseCoopers report.
Economic capital, says Guillermo Kopp, TowerGroup vp of cross industry, uses risk-weighted assessment in determining the financial stakes of a given action. "[It's] one thing to lend money to a blue-chip company that is doing well-let's say, for example, IBM-and another thing to lend money to a shaky startup with an uncertain future," he says. "So the same money, depending on how it is applied, has a different component of risk weight."
Of the more than 200 financial institutions surveyed worldwide, 44 percent of respondents claim already to be using economic-capital planning, and an additional 13 percent plan to do so within the year. The motivations are many, including improving strategic planning (68 percent); defining risk appetite (65 percent); improving capital adequacy; assessing risk-adjusted business unit performance and setting risk limits (51 percent); and assessing risk-adjusted customer and product profitability (43 percent and 41 percent, respectively).
Although it's based on theory from the 1950s and '60s, the concept of economic capital has been gaining ground in the financial industry only since the real-estate crisis of the early '90s left firms "starved" for capital, says Shyam Venkat, PwC partner. "And so they had to be able to figure out how to be able to deploy the capital most effectively, and sort of deploying capital in the direction of highest and best use," he says.
The shakeup motivated leading firms to figure out the most effective deployment of resources, which included using economic-capital planning to determine the amounts needed to withstand unexpected losses. "As the leading financial firms [began] to realize the benefits of using economic capital as one additional data point-as one additional technique to make business decisions-other firms have realized, 'Hey, this is a good thing to do, and we should be doing it as well,'" Venkat says.
So what are the benefits? According to PwC, better risk-based pricing and performance measures are among the chief advantages to an economic capital plan: More than 10 percent of survey respondents have discontinued sub-par products as a result of economic-capital findings, and about 20 percent have changed their pricing policies. Additionally, 72 percent of respondents anticipate having better distribution of resources with the economic-capital model than they would have with a regulatory one, with 22 percent already reporting they have freed up capital for business use.
Despite economic-capital planning's growing momentum, however, U.S. institutions have been slow on its uptake. The study finds that out of the 25 percent of respondents with no plans to adopt economic capital, 51 percent cite a lack of regulatory pressure as the reason. Breaking the numbers down is revealing: 27 percent of those with no adoption plans are based in Europe and 19 percent are in the Asia-Pacific region, but a full 37 percent are based in the Americas, where Basel II doesn't encourage economic- capital planning's use as much as elsewhere, Venkat says.
But while the number of U.S. financial institutions is smaller, those same banks were leading the charge in the '90s; Venkat says the sheer volume of American banks makes the issue a misleading one. "I would say that economic capital is becoming an industry standard, but is it something that is pervasive across all 6,000 or 8,000 banks in the United States? Clearly not," he says.
Kopp, however, puts it in stronger terms. "The challenge for U.S. banks is to step up to the plate and meet the emerging competitive standards that the banking industry has been adopting globally," he says, citing banks with international interests as the big players. "Globally active banks like Citi, JPMorgan Chase and Bank of America have taken the initiative to implement some sort of risk-weighted asset calculations."
Of the many banks contacted for this story, none would publicly discuss their economic-capital programs. As the PwC study reveals, 70 percent of the world's top 50 banks disclose the use of economic-capital planning in their annual reports; however, 44 percent of U.S. institutions don't plan to report their figures externally. Their unwillingness to comment speaks more to the issue of self-preservation in a highly competitive market than to a lack of implementation.
And although many large banks are in various stages of realizing economic capital, it could be years before it becomes an industry standard. "There are a number of building blocks that need to be in place before firms can strive to have a robust economic-capital program," Venkat says, citing risk aggregation and quantifiable diversification benefits. It's also important, he says, to have "good, robust data, cleansed data, so that you've got good input into the machine, and therefore you're yielding or generating good output so that you avoid the garbage-in, garbage-out problem."
Out of the top 50 banks surveyed, 64 percent say the difficulty of integrating decision-making processes within management is the major barrier to successful economic-capital implementation. Kopp agrees with that assessment. "The very first step is a convergence-that's exactly the word, a convergence-between the office of the chief risk officer and the office of the CFO," he says. "It doesn't mean that they've become one, but that decisions are analyzed in a more holistic perspective."
Other cited stumbling blocks include difficulty in quantifying certain types of risk (62 percent); problems with data integrity (59 percent); lack of incentives for cooperation among business lines and product areas (31 percent); lack of in-house expertise and uncertainty regarding regulators' attitudes (23 percent each); and a flat-out lack of support by senior management. "Making sure that they have very, very good senior management sponsorship and buy-in of economic capital programs within the institution determines success for any firm's economic capital-related initiative," Venkat says. "Management really has to be perceived as being active champions and advocates and users of economic-capital results for the economic-capital program within a bank to have any level of credibility associated with it."
