Heard on the High Street: the realities of working out economic capital and RWA

Recent conversations in London showed some of the realities of working out economic capital and risk-weighted assets models. Quotes are kept anonymous for obvious reasons.

One commenter discussed a model used by a major global firm that took some five years to build, a timeline that could be considered aggressive. And though traditionally mitigating credit and portfolio risk had well-defined boundaries in an organisation, big picture thinking has resulted in a deeper integration into the business-end – looking at capital allocation, returns, and how the firm is managing and servicing the client and reward structure.

“We set out to influence people’s behaviour in a positive way and that is quite an onerous thing because if you do it correctly you make a huge difference in your organisation in a positive way, but if you get it wrong, there is quite a bit of downside risk,” the person said.

The underlying methodology of the model is drilled down into scorecards with “ROE-type” performance measures. “The important thing is to align the behavioural aspects with your framework, tools and methodology so it is consistent,” the person added.

“At the heart of the new regulatory framework is the firm’s business model…(economic capital) is a really good tool that firms can use as an input into decision-making and really understanding how they run their businesses,” a person said. “(But) economic capital did not hold up that well in the crisis and the regulator has back-pedaled to make sure that financial firms have enough capital to be in business.”

Data and the unified systems required to pull everything together can be condensed into a neat diagram, but from a reality point of view the data required to implement economic capital methodologies requires a “very strong and robust framework that management need to buy into” said a recent commenter. In other words, dig in because these things will take longer than you might hope.

“The reason why any of the parts fail is often 50% data and 50% politics and I spend half the time being yelled at by business for being too conservative and half the time being yelled at by (senior management) for being too aggressive. As long as it is about equal I think I’m doing a good job,” said the person.

They added that senior management wants to know which parts of the business are high-performing, and being armed with evidence backed by analytics and reporting is powerful. “(Senior management) want to make sure that if people are getting a big bonus, then that is because they are earning it.”

“Someone (did not understand) the assets they wrote in the first place and how those assets would perform…if you are putting sh*t into your economic model you are still putting sh*t into your regulatory capital,” one commenter said, adding that there is general acceptance that “we are not able to measure stuff properly.”

“It’s too easy really to blindly follow for example in a commercial environment return on RWA… not thinking about risk. You want to price to the risk. It’s important you go beyond the minimum standard if you have got a model linked to your portfolio composition.”

Some related articles this past week from Securities Finance Monitor:

Banca d’Italia paper looks at factors behind RWA calculations, why they differ so much

BIS paper on regulatory simplicity is well worth the read; hopefully this is a shape of things to come

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