Faced with increased market volatility and competition, financial institutions need to clearly understand the risks they take. A new briefing suggests that economic capital systems are the answer. Sue

In essence, economic capital systems are a way of quantifying the risks faced by a business, of making sure that there is enough capital to cover unexpected losses, and that all expected losses are factored into pricing. But they do more than just aid in avoiding financial disaster.

A joint study between PricewaterhouseCoopers and the Economist Intelligence Unit, entitled Economic Capital: At the heart of managing risk and value, highlights the important benefits arising from establishing economic capital systems.

  • Economic capital systems allow financial institutions to quantify the risks they face and calculate both the capital they need to cover them and the real returns being made.
  • By making it clearer which ventures create the most value, institutions can take account of the cost of risk when planning future strategies.
  • The approach also enables them to reassess their investment strategies and to make better operational decisions in areas such as pricing and capital allocation.
  • In addition, it allows them to gauge their own appetite for risk and to ensure that they have enough capital to cover any disasters.

    However, while economic capital systems have become increasingly important to some financial institutions' decision-making, they have not swept the board. One likely reason is that the actual process of establishing an economic capital system is not easy. It involves collecting data on three main types of risks - credit, market and operational - as well as establishing a host of scenarios to cover the full range of possible outcomes. This can be particularly difficult in areas such as retail credit or operational risk.

    The report also warns that institutions implementing the system need to strike a careful balance between making accurate calculations and establishing a workable system that all key people can use and understand. Management commitment throughout the company is essential. While senior management buy-in is relatively easy, problems have often arisen further down the management chain. If divisional managers are resistant to the system, it will have been a costly and ineffectual exercise. Some institutions have ensured their economic capital systems really do dictate their strategy by linking them to employees' bonus payments.

    Guiding strategy
    The report says that it is only in the past few years that some of the biggest financial conglomerates have realised that combining myriad risk assessments for their individual business units and departments allows them to work out the risk and capital requirements across the whole group. This helps to guide strategy, as they can compare the economic profit of each business unit more fairly, discounting the performance of high yielding but risky sectors. And this ensures efficient capital allocation.

    The biggest impetus towards adopting economic capital systems comes from the pressure for higher returns in an environment of increasing volatility. Even the smallest financial firms are under increasing pressure to improve their internal risk assessment systems. Although introducing an economic capital system is expensive and difficult, the report says that the result can completely change the way companies think about their profitability.

    Institutions that do not disclose their economic capital calculations to shareholders and other stakeholders risk undervaluing their company. According to Phil Rivett, global banking and capital markets industry leader, PricewaterhouseCoopers: "A company's return on economic capital can give a far clearer picture of its real returns and changes in shareholder value. Without these figures, analysts and investors will tend to make conservative assumptions that will, in all likelihood, undervalue the company".

    Economic Capital: At the heart of managing risk and value is available from www.pwcglobal.com/financialservices

    Sue Copeman is editor, StrategicRISK

    The study suggests ten rules for companies that want to implement this approach. These can be summarised as:

    1 make sure the whole management team is behind the project

    2 discuss the proposed system with regulators, to check that it fulfils their expectations

    3 remember that, although data is critical, judgment and experience are also vital ingredients, so do not be too pragmatic. You can always refine your calculations once you have the system up and running

    4 research what risk data is available in the market place so that you can draw on the experience of others as well as your own

    5 keep up with the latest thinking - standard methodologies and adaptable software have developed, especially for credit and market risk

    6once your system is in place carry on educating managers and give them an interest in making it work

    7 decide how far down the company you want to extend the system. this can vary according to the organisation involved

    8 make sure that enough people understand the system to maintain continuity if some leave

    9 be transparent both internally and externally. Analysts, investors and other stakeholders need to understand the figures and what they mean for your strategy

    10 remember that economic capital systems work best when they are part of a coherent decision-making process; stick to consistent principles when it comes to measuring, managing and rewarding performance.