Capital: Protection from the storm


5 December 2011


Basel III-led financial regulators want to protect the banking system by enforcing increases in both the quantity and quality of financial institutions’ capital. However, according to Dr Evgueni Ivantsov, head of portfolio risk and strategy at HSBC, strengthened capital ratios are by no means a guarantee of surviving turbulent times. Nigel Ash investigates.


We have seen some financial institutions, which were among the strongest in terms of capitalisation, fail as a result of the financial crisis," says Dr Evgueni Ivantsov, HSBC's head of portfolio risk and strategy. "Meanwhile, some others from outside the capitalisation 'premier league' survived. So this means that capital does not tell you the whole story."

In his view, the fundamental cause of the global financial crisis was not an insufficiency of capital per se, but the failure to manage tail risk properly, a vast amount of which was accumulated by the financial sector in the benign period. It then failed to mitigate its impact when the tail risk events struck, which led to the subsequent massive losses that eroded banks' capital. He believes the enduring crisis continues to demonstrate that the industry is not good at dealing with the tail risk - also known as black swans - that arises in a perfect financial storm.

Fix the right problem

The Basel III focus on capital adequacy tends to overshadow other approaches to risk management and mitigation. Ivantsov produces an unusual analogy:

"Suppose you are the minister of transport, responsible for an effective transport system and suddenly you can see that there are a lot of problems with the traffic, resulting in an unacceptable level of severe accidents and casualties on the roads. You need to take particular action to change the situation. What is your solution? You can say that because there were too many accidents and many people have lost their lives on the roads, we need safer vehicles. So what is the safest vehicle? It is the army tank. So then, as the regulator, you impose a law that from 2019 all car owners must upgrade their cars to army tanks. To your critics you reply, 'Yes we know this is an expensive solution, possibly the driving experience would not be as enjoyable, but we expect that, with people driving army tanks, there will be fewer casualties."

This radical solution, however, ignores the deeper analysis of why roads have become so unsafe and asks the question whether it is actually the safety of the cars themselves that is the problem.

"The main reason," he continues, "is actually that the drivers have poor driving skills, poor discipline and possibly drink-driving problems, and this causes the huge amount of accidents. So then the solution should be, in parallel with improvement of car safety, to restore road discipline, educate drivers and help them to manage their risk properly."

"By the time a bail-out is necessary, it's already too late. Regulation and control should start at the very early strategic stage, when financial institutions first define their risk appetite."

At the moment, says Ivantsov, Basel is focused on building safer cars in the form of more strongly capitalised financial institutions. Yet he argues that capital is merely a financial buffer.

"It is just an airbag that helps soften the impact. However, it only answers the question of who is responsible for taking losses - shareholders or the taxpayers and creditors."

Ivantsov argues that this does not address the question of reducing writedowns and losses from the impact of tail risk events.

All-round enhanced risk management may now be a given, but he believes that tail risk needs to be treated as a special problem, rather than being mixed up with normal risk. By its very nature, tail risk is different not only quantitatively but also qualitatively.

Heads or tails?

Ivantsov calls this problem "heads or tails". The head risk means normal everyday risk, which is always on the radar, while the tail risk represents extreme events with a low probability and very high severity.

"Because of their different natures, systems, tools, procedures and governance should clearly separate the two risk types and address them accordingly," he adds.

It has not helped that financial institutions have pursued short-term targets, typically return on equity, focusing on quarterly results. Ivantsov does not necessarily subscribe to the rising view that return on assets, rather than on equity, is a more reliable and therefore valuable metric. His analysis is that short-termism means that management ends up failing to see the wood for the trees.

"Risk management may now be a given, but tail risk needs to be treated as a special problem, rather than being mixed up with normal risk."

"In my view," he continues, "what can help is to set up the right long-term strategy, and part of this strategy should be risk appetite. This risk appetite should be focused on the long-term target rather than on short-term ones. It should be clearly explained how much risk this financial institution is willing to accept in the long term and what risk should be absolutely excluded from its business."

It is incumbent of regulators, says Ivantsov, to focus on the business strategy and risk appetite of banks and other financial institutions.

"If you look at the failure of the large financial institutions in the last crisis, you can see that the primary cause was the massive mistakes in their business strategies or flawed business models. That is why risk appetite is a vital strategic piece that should be monitored by regulators."

By the time a bail-out is necessary, it's already too late. Regulation and control should start at the very early strategic stage, when financial institutions define their risk appetite.

"Risk appetite is not only a set of financial metrics such as return on equity or return on risk. It is a more qualitative assessment where a financial institution needs to define its own comfort zone. This is the traditional business area where it has competitive advantages, a strong risk control track record and experience of successful dealings with extreme risks. It should set out to strike the right balance between business that is within and outside the bank's comfort zone.

Most of the banks that failed or faced significant problems in the last crisis paid a high price for ignoring the risk of running business outside their comfort zone. They started to build business that was very new to them and began to penetrate the industry very aggressively, without having enough experience or fully understanding the potential risks."

Be prepared

Ivantsov's view is that, in addition to profound risk appetite, all financial institutions should have an effective tail risk crisis management framework to deal with the exceptional challenges when tail risk events unfold. Early warning signals of a coming crisis need to be clearly identified. Stress testing will have given a picture of the dangers and help to prepare detailed contingency plans. A crisis governance structure should be established well in advance, in which roles are clearly allocated for the management of the crisis.

"In addition, IT systems and management information and reporting should be set up in such a way that they are able to provide the decision-makers with the right information during the crisis. In normal situations, we have a completely different management information system, which is all set up for heads but not tails."

Particular attention, he says, should be paid to crisis communication, drawing on the lessons learned in the past four years, when communication has been seen to help to resolve rather than amplify a crisis.

"The tail risk crisis framework is the last line of defence, and it is crucial that all banks and all financial institutions have this in place when they are hit by a perfect storm."

Once the crisis management piece has been established, it needs to be tried out regularly in what Ivantsov likens to
a flight simulator - the artificial environment thrown up by stress testing for different tail risk events.

The views expressed in this article are personal views of Dr Evgueni Ivantsov and do not necessarily reflect the views or policies of HSBC.

HSBC does not guarantee the accuracy of statements included in this article and accepts no responsibility for any consequence of their use. Terminology used may not necessarily be consistent with official HSBC terms.

Ivantsov’s view is that, in addition to profound risk appetite, all financial institutions should have an effective tail risk crisis management framework to deal with the exceptional challenges when tail risk events unfold.
Dr Evgueni Ivantsov is head of portfolio risk and strategy at HSBC, where he is responsible for reshaping the risk management approach and developing strategic solutions to improve the risk/return profile of the bank’s portfolios across key customer groups in the European region.