Frans de Weert
The importance of different
perspectives and implicit
assumptions in models
Amsterdam
7 November, 2013
1
Objectives
•
Different perspectives to capital management
•
The importance of models when managing capital
•
The incentives of regulation and its impact on model optimization
•
The self-fulfilling prophecy of models
•
How to mitigate the self-fulfilling prophecy
2
Capital management has two primary objectives: optimise capital
structure and optimise performance
Optimise capital structure
Optimise performance
Fulfil regulatory
requirements
Translate strategy
into capital
allocation
Satisfy stakeholder
expectations
Optimise economic
profit per business
line
Value
Determine optimal
level of debt
financing
Evaluate
performance per
business line
Make optimal
corporate finance
decisions
Optimise capital
allocation
Optimal cost of capital
Optimal return on capital
3
Capital management is about how a bank manages its available
capital against its required capital
Assets
Liabilities
Capital management
Equity
Available capital
Subordinated
Debt
Business
Lending
Deposits
Required capital
Financial
investments
Wholesale
funding
4
Several perspectives have to be taken into account when
managing this relationship
Capital perspectives
Regulatory
Risk
Worl
d
Capital
management
Accounting
Corporate finance
5
One capital model cannot capture all of these perspectives
Interest change
Capital perspective
Impact
Regulatory
capital1
X
Economic
(Market
consistent)

Technical
provisions
1
Assumes that regulatory capital is calculated under Solvency I, that reserve adequacy surplusses are not taken into account,
and that interest rate change does not influence the outcome of the test
6
That is why it is so important to understand the tolerance of each
stakeholder towards the capital position
Capital tolerance versus impact of irrational behaviour
= tolerance and impact shift due to nervousness
Impact irrational behaviour
High
Policy holders
Equity holders
Unsecured
lenders
Subordinated
lenders
Secured lenders
Low
Capital level
Low
(High tolerance)
High
(Low tolerance)
7
Nevertheless, models are crucial for getting a feel for
(complicated) risks or ‘adding’ different risks
•
Models can be quite powerful since they can make abstract
risks concrete
•
Once risks are concrete you can talk about them, manage
them and capitalize for them
•
Moreover, it enables you to weigh risks against opportunities
8
Moreover, economic capital models can help in comparing the
performance of different businesses and can therefore be used
to allocate capital
Raroc
Cost of capital
Economic capital
9
Basel III forces banks to think about the size of their balance
sheet
Long balance sheet model
(Dutch Banks)
Short balance sheet model
(US / Spanish banks)
Available Capital
= Economic
capital
Available Capital
= Economic
capital
Risky assets
Liabilities
Safe assets
Liabilities
10
Solvency I is effectively a non risk-based leverage ratio limit
while Solvency II is purely a risk-based framework
Solvency I
Solvency II
• Capital requirement is effectively
determined by taking 4% of the
technical provisions
• Solvency II takes a risk-based
balance sheet approach to
determine the capital
requirement
• Market risks (e.g. interest rate,
equity, spread risk), insurance
risks and operational risks are all
taken into account when
determining the capital
requirement
• Solvency II does not know a
leverage ratio
• Because the ratio between
capital and technical provisions
determines the leverage ratio,
Solvency I effectively is a
leverage ratio limit of 25
• Risks of asset investments are
not taken into account when
determining the capital
requirement
Incentive to invest technical
provisions riskily
Incentive to de-risk and
leverage
11
Because of the incentives from regulation, banks and insurance
companies optimize their balance sheets (including model
assumptions) to generate the highest return on capital
•
Banks and insurance companies try to maximize their return
given a certain amount of equity
•
Regulation determines how much capital certain assets
consume
•
The capital requirement is quite often based on model
calculations
•
If a bank or insurance company maximizes its return on
capital given a certain amount of capital, it will optimize its
business but also model assumptions
12
This results in a self-fulfilling prophecy where banks and
insurance companies become dependent on the (implicit)
assumptions in models
•
Since the models are optimized to generate the highest
return on capital, the capital requirement becomes
dependent on the implicit model assumptions
•
This results in a self-fulfilling prophecy where models are
constantly optimized further to be able to do more of the
same business
•
This ultimately results in a negative feed-back loop where
one becomes more and more dependent on the implicit
model assumptions
13
Even though the effectiveness of bank responses to the credit
crisis had nothing to do with the quality of the models
Example
1
Example
5
Denial
Lehman Brothers
2
Just in time
Barclays
Exploit the
crisis
JP Morgan
Quick to
respond
HSBC, BNP Paribas
Position well
for after crisis
Goldman Sachs
6
Ineffective
response
Citigroup
3
7
Catch a falling
sword
Bank of America
4
8
Surrender
Merrill Lynch
14
There are various mitigating factors for the negative feedback
loop
•
Model developers highlight the main (implicit) assumption of
the models and under which circumstances the model leads
to bad decision making
•
Senior management understands the key variables and
assumptions of the models
•
Senior management tries to take several perspectives into
account for decision making and stimulates the use of
several models instead of trying to incorporate everything in
one model
15