Online Finance – Building a business case for risk management

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The business case for Risk Management

Basel II and the Capital reduction argument

The traditional business case for Basel II has relied on the capital reduction argument. The pitch is that the Basel II framework should allow you to better allocate and price for risk capital. Your improved capital allocation strategy will lead to assets with lower risk weights and a lower capital charges. On the market risk capital side, you also get diversification benefits when you run a large portfolio. The capital saved can be redeployed or returned to share holders.

In emerging markets, there is a problem with the reduced capital charge business case. In some markets for instance, you may not use internal models for market risk, IF you are not using similarly advance models for credit risk. Since the average credit portfolio in these markets is rated just below investment grade, any savings realized on the market risk side disappear when the revised credit capital charge for credit risk is calculated. It is possible for your revised capital charge to be neutral or substantially higher than your existing numbers.

This throws the traditional sales pitch and Return on Investment (ROI) calculations for Basel II out. Is there an alternate approach more suitable to clients that operate in these markets?

The resource leverage argument

What would (or does) it take for you to comply with your Basel II reporting night mare. You download transaction data from your core banking application, price data from your Reuters feed, deploy two to three resources at the officer level, put a CxO facing manager on top and build your capability to do Basel II reporting with Excel, text files and MBA’s. This represents Basel II strategies of most small and midsize emerging market banks.

There are four serious problems with this approach; first given the shortage of Basel II, risk and quantitative skill sets, resource turnover within risk management groups is higher than average. A month before your quarterly reporting cycle is due, your key resource walks out. Do you start all over again?

The second problem is scalability within Excel. Even though you can automate stuff to a large extent using VBA, there are only so many Monte Carlo simulation or variance covariance matrices you can build within a spreadsheet. Easy access to archived data, running comparative benchmarks, cleaning up large data sets or simply scaling up the solution to a bigger portfolio is a fair amount of work.

The third problem is boredom and resultant human errors. Try explaining who is responsible for a capital adequacy deviation or a last minute shortfall to an irate board member or a regulator.

Finally for a risk management framework to be effective and functional you need to deliver on risk measurement, risk analysis and risk control. Within small risk management teams, the measurement effort takes so much bandwidth that the analysis and control function doesn’t get done. To fix this problem you need more resources. Even if you have the budget, the resources are difficult to find.

The essence of the resource leverage argument is that you take your smart MBA’s and give them the infrastructure that does the measurement grunt work. The three people that it took you to get your portfolio, your price feed, your contracts, your parameters in and your internal and regulator reports out are now free to focus on the analysis and control piece. You don’t have to hire three more resources for analysis and control. What is that worth to you?

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