CHALLENGE OF THE MONTH

10.2009

NEW: How Business risk is understood by the top 50 world banks? Are you part of the best practionners?

The financial crisis, started in summer 2007 in the subprime markets, has provoked multi-billion dollar losses and put an end to a long period of strong and steady growth in the investment management industry. Investment management firms have now to find new value growth paths in order to survive and remain competitive in the marketplace. Based on extensive research on strategic risk management in the literature, analysis of current practices among the world top 50 banks, and interviews of several major financial institutions, we argue that to achieve and maintain value growth, it is essential that this growth is sustainable. Secondly, sustainable growth requires improving understanding and management of growth risk, a category of strategic risk often neglected in the past whereas it can be the most serious cause of value destruction as experienced nowadays by several major financial institutions. Besides providing a clear definition of the concepts of strategic risk and growth risk, this research aims at presenting a pragmatic and flexible for managing growth risk and hence ensuring sustainable value growth.
For more information on the topic, please contact us: info@sagora.eu

04.2007

Risk Governance

An adequate implementation of the Basel II Accords is more than a matter of capital computation as it affects the complete structure of the bank in terms of risk management implying a need for a change in the mind-set of all relevant staff. Indeed, the so-called Pillars II & III are the pillars that have important implications on the way a financial institution should be organised. They deal with the corporate governance, risk governance, internal control, reporting, market discipline and relationships with the banking supervisors. The implementation of those pillars is the primary element to be considered and to focus on. Indeed, once they have been implemented or a clear roadmap to achieve the target objectives has been defined, the organisation may consider the needed risk management tools to ensure the adequacy of capital with the institution?s risk profile. Through its proprietary framework, SAGORA helps institutions to deliver quality throughout their organisation to create opportunities in line with the objectives of the financial institution that comes on top of pure regulatory compliance.

07.2006

Adequate risk-adjusted performance measurement

Raroc challenge

Today, it is widely agreed that traditional financial performance measures such as ROE and ROA are not anymore adequate to analyse the performances of a financial institution. The diversification of the banks and the creation of many different business units entail a real need to use new tools designed to truly measure the return and the risk of a bank?s business unit.

A wave of new financial tools has appeared during the 1990?s, all of them based on the principle of Risk-Adjusted Measurement Performance (RAPM) and Economic Capital. The most famous one is the Risk-Adjusted Return On Capital, or RAROC.

RAROC can be the nexus of value creation for shareholders if it is well and smartly used. However, many pitfalls and traps are linked with the use of RAROC. Not being aware of these traps can lead to biased strategic decisions and adversely affect shareholder value.
The next few points may help you to question yourself about the relevance of RAROC and the possibilities to adjust this tool:
1. The numerator of the RAROC represents the risk adjusted return, which is roughly the net margin less the expected losses. Does the financial institution have the sufficient data and statistical tools to compute these expected losses? Does the financial institution able to calculate downturn expected losses?
2. Expected losses are based among other things upon estimated default frequency (EDF). Many institutions don?t pay enough attention to the computation of this EDF, which may lead to a flawed RAROC, and then not adequate capital allocation for instance.
3. How should be measured the economic capital? Should the institution take the regulatory capital or the economic capital? Should it take into account credit risk or all kind of risks into account (including operational risk, concentration risk, diversification effect, etc?)
4. Is it appropriate to apply a given hurdle rate to all activities?
5. Is it appropriate to apply a hurdle rate when you deal with a large amount of fixed costs and the capital is not entirely absorbed?
6. How far can we trust RAROC as this measure depends upon the volatility of the returns? An implication is that, for important volatility, RAROC may be below the hurdle rate, even for an investment with a positive NPV.
7. How do you ensure that economic value added and RAROC measurement are consistent? How are these measures reconciled?
8. In the lending activity, is the whole interest amount recognized as revenue, or should a part be considered as provision for future credit risk?
9. How can the risk on interest rate been managed when you work with multi-period loans?

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