BID® Daily Newsletter
Jul 25, 2012

BID® Daily Newsletter

Jul 25, 2012

THE CONVEX NATURE OF CAPITAL RISK


Convex mirrors can be found in many offices all over the world, creating a wide angle view that can be quite handy at times. They enhance security and stop people from crashing into one another when they turn a corner at work. Convex mirrors are like normal mirrors in that they both reflect back light, but convex mirrors make the light rays appear to spread out because the mirror itself bulges toward the light. Since most bankers don't make a lot of loans on mirrors or mirror companies, we will now end our science discussion before you begin to get a headache and wonder how those mirrors in hotel bathrooms can zoom in so close on your face that you can see imperfections only visible to a gnat. Speaking of mirrors that help you see around corners, you should know we are now in an era of banking regulation called "dynamic capital supervision." This change began after regulators concluded that static capital management is too blunt a tool given changing risk profiles post crisis. The beginning point of this evolution revolves around stress testing. No, we are not talking about loan stress testing, but rather capital stress testing. The idea is that doing so gives bank management teams and directors a good idea of what sort of capital situation they could be in during an adverse situation. Then, capital stress testing asks the question - what are the odds that a given situation (stress) could happen, what capital and liquidity you would have if that occurred and what steps you would take in what order to mitigate the impact of the event (your contingency plan). In a nutshell, this new dimension of bank regulation takes traditional static views of capital ratios and enhances them with forward- looking analysis to get a better understanding of the impact of various events in an ever-changing industry. Regulators look to stress testing to assess the capacity of a bank team to understand and manage their capital position, evaluate capital distribution plans against overall capital positions and make sure the bank meets all capital requirements on a going forward basis despite a shifting environment and new regulation (such as Basel III and other new capital rules that are currently out for comment). Another way of thinking about this is to consider that stress testing is a forward looking and dynamic process. That means management teams have to think about what scenarios they are going to run and why. This very process results in benefits to the organization that some might say are as important as running the test itself. As a tool in the banker's tool box, stress testing is useful when analyzing capital, liquidity and other areas of risk that reside in the bank. We have all learned many lessons during this period of economic crisis and one of them is the added value of testing how to protect capital using dynamic techniques that change as economic or industry conditions require before an impactful event actually happens. Preparation is critical to avoid making hasty decisions under duress and dynamic capital analysis does just that. Whether your team is trying to reduce the risk of shocks that could jeopardize your ability to meet obligations, or you are testing strategies you might employ to gain market share or customers, dynamic capital planning can be beneficial. As you round the next corner in capital planning in banking, don't forget to look up and use the convex mirror placed near the ceiling as a dynamic way to avoid bumping into something that might not be easily seen.
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