Today’s banking industry must deal with an evolving regulatory landscape by developing new and innovative strategies for acquiring and optimizing capital. Banks must find a new way to raise capital, maintain a functional capital structure, and continue providing the products and services their customers demand while staying profitable. The new deadline for implementing the Basel III capital requirements makes capital management the most important issue for banks today.
Bogie Ozdemir, Vice President, Risk Models and Governance, Sun Life Financial recently spoke with the Global Financial Markets Intelligence (GFMI) about key topics to be discussed at the upcoming GFMI 2nd Annual Capital Adequacy, Strategy And Stress Testing Conference, September 30–October 2, 2013, in New York.
What are the key implications of Basel III for capital adequacy and capital optimization?
Bogie Ozdemir: Basel III amounts to a climate change in the banking industry. It increased the capital requirements significantly — especially for certain businesses (most notably capital markets) and decreased the acceptable forms of capital. Capital has become a scarce resource under Basel III, putting significant downward pressure on ROE. In this new environment, Banks will need to change their business mixes, exit or shrink capital-heavy businesses, and adjust their operating models, while meeting income targets. During this course correction, their ROE and Income Targets will be challenged further as some rebalancing of operating models may compromise short-term income to improve ROE in future years. Subject to more onerous capital requirements under Basel III, banks will need to increase the efficiency of capital utilization and place greater emphasis on optimizing capital allocation and business mix across their operations.
How could banks integrate their regulatory and economic capital?
Bogie Ozdemir: Regulatory capital is a fact of life and cannot be ignored. The economic view of capital also must not be ignored, as most recently seen in the J.P. Morgan case where attempt to reduce RWA consumption resulted in massive increase in economic risk and, ultimately, losses. On the insurance side, products such as variable annuities emphasize the importance of understanding economic risks that may not have been covered by regulatory capital requirements. The first order of business is to control the regulatory capital, which becomes the binding constraint for certain business. But regulatory capital and economic capital must be co-managed. I have noticed some banks using more simplistic — but not very robust — ways of managing the two, such a creating a composite metric that is a mix of economic and regulatory capital. Banks should establish a more robust optimization framework, define an objective function (such as maximizing ROE), and define explicit relationships between regulatory, economic (and its stressed version), and available capital. This framework should be a part of their capital and strategic planning process.
What are the best sources of funding in this scarce capital environment?
Bogie Ozdemir: Contingent capital is becoming a viable source of funding undergoing concern. Junior Debt would be a source of capital under the “gone-concern” to protect deposit holders (and perhaps senior debt holders). By more carefully managing capital through ongoing and gone concern bases through an Economic Capital Framework, financial institutions can be more precise as to their required capital mix across common equity, senior debt, junior debt and hybrid instruments, and therefore minimize the average cost of capital.
How could you make sure stress testing results are integrated in capital strategy?
Bogie Ozdemir: We know from the last crisis that EC can increase significantly under stress — particularly when taking into account stressed inter and intra risk correlations. In their ICAAP/ORSA exercises, FIs define an explicit risk appetite under stress (minimum acceptable rating and capital adequacy) and ensure that they remain consistent with that risk appetite under a series of forward-looking conditional stress scenarios. As part of the Use Test under ICAAP and ORSA, FIs should demonstrate how the results of their stress testing and capital projection exercises have been incorporated into business planning decisions. In particular, the results of stress testing are used directly to inform the appropriateness of an FI’s capital buffer above its internal targets and whether the integrity of its capital structure is sufficient in stressed conditions. Degrees of vulnerability to stress must also be considered as part of capital optimization strategies.
Bogie Ozdemir is Vice President of Sun Life Financial Group, responsible for Enterprise Economic Capital, Operational Risk, Model Vetting & Risk Analytics, Risk Policy, and Economic Scenario Generation groups. He was a Vice President of the BMO Financial Group responsible for Economic Capital, Stress Testing, and Basel Analytics and jointly responsible for ICAAP. Previously, he was a Vice President of Standard & Poor’s Risk Solutions group, where he was globally responsible for engineering new products and solutions, business development and management. He is the coauthor of a book titled “Basel II Implementation: A Guide to Developing and Validating a Compliant, Internal Risk Rating System.”
The GFMI 2nd Annual Capital Adequacy, Strategy and Stress Testing Conference will take place in New York, September 30–October 2, 2013. For more information, visit the event website.
For more information, please contact Michele Westergaard, Senior Marketing Manager, Media & PR, GFMI at 312-894-6377 or Michele@global-fmi.com.