Economic capital and other advanced risk-based capital methodologies enable financial institutions to quantify the risks they face, the capital needed to cover them and the real risk-adjusted returns that are being made or should be targeted.
While interest in such frameworks is increasing in the wake of the move to risk-based prudential regulation including
Basel II and
Solvency II, the overriding benefits are the ability to enhance strategic and tactical decision-making and optimise shareholder wealth. Risk-based capital evaluation can help organisations to spot threats and weaknesses; identify opportunities that may be missed by competitors and target investment where it can earn its best return. It can also help to align risk appetite with capital allocation and communicate the tangible strengths and potential of the business to analysts, investors and rating agencies.
"Effective capital management: Economic capital as an industry standard", a survey of more than 200 financial services executives carried out by PricewaterhouseCoopers in 2005,found that 44% of institutions questioned were already using economic capital and a further 30% planned to do so. It is significant that improving strategic planning was seen as the primary reason for adoption, rather than helping to meet regulatory requirements.
Yet, the findings cast doubt on whether there is sufficient group-wide understanding and buy-in within many organisations to ensure that such frameworks deliver the business benefits. In particular, it would appear that most of those who understand the business applications of economic capital are risk managers rather than risk takers. Only 11% of the board and 14% of business units were seen as extremely knowledgeable compared with 45% of the risk management team.
A further drawback is the lack of embedding within many organisations. Only 11% of respondents said that business units have primary responsibility for managing economic capital. The dissemination of information is also patchy, with 21% of unit heads only receiving economic capital reports on an ad hoc basis and 24% not at all.
Transferring authority for economic capital to individual business units where possible could help to boost awareness and uptake. The survey also underlined that, as with all models, the process requires frequent calibration, validation and the sense check of management experience and intuition. Indeed, this is just one of many important reasons to ensure the involvement of people on the ground.
How PwC is assisting financial services organisations
PricewaterhouseCoopers has a proven track record in the implementation and development of risk-based capital management through design, build, integration and validation.
The basis of our approach is the recognition that risk-based capital management and its underlying assumptions require constant challenge, refinement and alignment with the specific characteristics of the business to ensure the framework can provide a credible source of information, assurance and insight for management.
