Many bankers are employing a botox business strategy of reaching for yield in the current low return environment. It involves toxic injections of risk to cover up performance wrinkles. Unfortunately, it has potentially ruinous long-term side effects. The strategy is based on the mistaken belief that risk creates return. Thus, if you cannot get desired returns from safe investments, then all you need to do is turn up the risk appetite thermostat and take more risk.
Recent pronouncements from Barclays, UBS and consultants on the need to increase risk appetite are evidence of this trend. They are unlikely to be more successful than previous supporters of this strategy.
Risk may be correlated with return. Risk is not, however, the raw material generating return. If risk caused return, then it would not be risky, and Jimmy Cayne and Dick Fuld, among others, would still be on Wall Street. The delusional belief that risk creates return puts the cart before the horse by confusing correlation with causation. Investors take risk and receive a return. This does not mean they received a return because of risk. Rather, return is based on skill in creating value and managing risk. Taking risk to generate nominal returns, however, is easier than creating a value added service that satisfies a client need. Thus, absent strong board of directors’ oversight, managers will focus on nominal returns as a key performance indicator instead of risk-adjusted return value drivers. This encourages increased risk taking even though the institution is undercompensated for the incremental risk.
Risk represents exposure to the consequences of uncertain events. It is a cost of return and not an opportunity. Seen in this light, it is something to be reduced – not increased. Additionally, it has capital implications. Higher risk without higher capital is like building in a flood plain without flood insurance. Capital is needed to absorb the volatility. Of course, the increased capital reduces return on equity, which illustrates risk alone does not increase value. In fact, many banks confuse investors with high returns based on risk not skill. Ultimately, the reality becomes clear resulting in "surprise" losses, shareholder value destruction and management changes. Despite this fact, banks continually make the same mistake concerning risk. This is largely due to the difficulty in measuring risk because it is not observed.
We see only losses after risk is realized. Risk is usually and mistakenly measured by extrapolating historical loss data to calculate a capital change known as economic capital. The charge is deducted from an investment’s return to approximate a risk adjusted return. Risk, however, is not static. It evolves in ways not fully understood. The nonstationary business cycle related macro component of risk is typically not reflected in the recent historical data and consequently is frequently ignored. Consequently, economic capital is understated as many banks discovered during the crisis. Losses tend to occur infrequently, but their effect is large. Since there are usually more good years than bad, high-risk strategies can appear successful for long periods of time. During a bull market, those who take on more risk win.
A longer term risk horizon of 10 or more years is needed to incorporate black swan type shocks. Reliance on a trailing weighted average of returns misses periodic shocks which can swamp shorter term averages. Not only does risk evolve over time, but so does return. As popular asset classes, like commercial real estate pre-crisis and commercial and industrial loans post crisis become crowded, returns fall requiring even higher risk levels to maintain return levels.
Avoiding permanent capital loss through skillful risk reduction represents a competitive advantage. Nonetheless, this fact received little attention pre-crisis during which time many banks were seduced into thinking they could not lose. Also, higher short-term nominal returns are more exciting than lower long-term risk adjusted returns, especially for bonus purposes.
There is nothing wrong with high risk-high return strategies provided the volatility implications are appreciated. The first cut is whether the institution has the skills needed to manage risk to an acceptable scenario based stress level. Next, sufficient capital and liquidity are required to withstand shocks.
The mechanical risk-return relationship inherent in the risk thermostat view of setting risk appetite and business strategy is wrong. Markets are more complicated than many managers believe. Sustainable long-term returns are dependent on skill in managing risk, and not just in taking more risk. This is a subtle, but critical distinction. Banks are paid for being right – not just for the possibility of being wrong. Thus, the future belongs to those banks who understand and serve customer needs, and not to those who simply take more risk.
Joseph V. Rizzi is a senior strategist at CapGen Financial Group, a private-equity firm. He spent 24 years at ABN Amro Group and LaSalle Bank.