The Hindu Business Line : Basel II isn't the name of a movie

CONCLAVES of CAs rarely talk about Basel II, as if it were a chocolate recipe or a movie name. When will they ever know that it is the New Capital Accord that will require financial institutions to manage risk by aligning regulatory capital to economic capital, disclosing greater risk info to investors and setting standards for internal risk management processes? "Complying with Basel II will require a significant investment in risk management," writes David P. Belmont in "Value Added Risk Management", published by Wiley (www.wiley.com).

Do not expect such an investment to yield fruits to shareholders without an ability to measure economic capital, cautions the author. "Because economic capital quantification enables risk management to reduce the volatility of earnings; assist in determining an optimal probability of bank default; optimise the bank's associated capital structure; and provide valuable input to strategic decision-making."

Accountants know profit in all their forms, but ask them about economic profit, they may probably draw blank. "Economic profit is a sophisticated modification of cash flow that looks at the cost of economic capital and the incremental return above that cost as a way of separating businesses that truly generate economic value from ones that do not," explains Belmont.

Here is a take-away formula: Net operating profit - taxes - cost of capital = economic profit. Thus, "a firm's economic profit is the difference between its revenue and the alternative highest return that capital employed could earn in its best alternative use."

Before you dismiss that as irrelevant, note that accounting earnings fail to include two important expense items relevant to shareholders: "The opportunity cost of capital contributed by the investors in the firm, and the risk inherent in the activity being evaluated." So, "performance measurement in banking has progressively evolved from pure revenue measurement to ROA to ROE to RORAA, ROROA, RORAC and ultimately, to RAROC." Don't miss the detailed illustration on RAROC in the book.

For banks, risk management creates value in many ways, points out the author. "Banks can use risk controls to avoid unnecessary losses. They can set risk limits to reduce the probability of risk concentrations that result in unacceptable losses and increase diversification in their portfolio."

We often hear about potential bank mergers, with sick ones getting absorbed by healthier ones. "Acquisition and divestment decisions are of great strategic importance to financial institutions," writes Belmont. "Economic profit and RAROC provide a strong framework for approaching these complex strategic decisions."

An interesting graph with four quadrants plots RAROC on the X-axis and PV of future risk adjusted returns on the Y. Sub-prime lending and asset management are in the high-performer category of the top right quadrant. "Asset management uses little economic capital but creates a superior RAROC and positive economic profit," explains the book. Sub-prime lending consumes large amount of economic capital and produces high RAROC, but the bank has to "cherry-pick its borrowers from the sub-prime population"; also, this is cyclical. Ideally, banks should incorporate all these risk-analysis tools before decision-making at the transaction level.

A separate chapter discusses the use of IT in measuring risk. Software that provides a RAROC calculator would be an integral part of any successful automation, though Basel II does not require that banks calculate their RAROC.

"However, a bank that extends its risk system to not only comply with Basel II requirements but to also allocate economic capital and which has a strong financial reporting system has all the components necessary to produce RAROC information," the author would reason.

No risk if you read this, but the converse may be true, so get ready before Basel II hits the small screen of desktops.

mail to:BooksOfAccount@TheHindu.co.in

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