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RISK FOR FINANCIAL INSTITUTIONS AND INSURANCE

The convergence of banking and insurance business interests has led to M&A across the industry. Banks in Europe have recognised the benefits of M&A for banks with insurance companies. Cross-selling and strengthening the capital base and skills base. The new business model was clearly aimed at selling insurance products through the bank’s network, so increasing synergistic revenue. This will satisfy a larger proportion of customer service needs through a one-stop shop.
Risk management methods of both professions must cross-fertilise each other. This has been expected to happen quicker than both professions can imagine, but already we have many situations where big insurance companies, e.g. SwissRe, MunichRe, AON, AIG lend money to business. The Prudential Assurance owns Egg Bank in the UK, while Lloyds-TSB Bank owns four insurance companies including Scottish Widows. Which major bank does not own an insurance company? They perform corporate and trade finance functions in the same manner as banks.
It becomes difficult to manage the different enterprise cultures required in one new organisation. Change management and a modified Weltanschauung (world view) are needed for the merged entity, especially if your bosses have been changed. Furthermore, financial structures will change and the ground can shift under your feet. Insurance companies used to rely on a steady and relatively predictable revenue stream from customers’ premiums. They have found that new income volatility from the investment banking side had a damaging effect on their retail market financial health.
Risk structures and risk appetites may change in the merged corporation, so organic risk management should analyse the likely behaviour of this new investor animal. Insurers’ initial risk perception was more optimistic than it should have been. Some of this stems from the positive risk outlook from marrying a prestigious investment bank. Similarly, the big four UK clearing banks in 1986 tried to nurture an investment bank for their retail banking business. All four have retreated from this ambitious business strategy to various degrees. They should have put pessimistic scenario into their risk plan. Risk has a price, and many merged bancassurance companies initially had a rough ride.
Nevertheless, insurance offers significant contributions to banking, both in terms of crossselling and tapping a skills base. Basel II sees that insurance will become more closely linked to banking and fund management as the finance industry develops. Credit-ratings agencies and insurance companies will be inextricably tied to banks and funds because market transparency means that relative rankings of company “risk” become public. These directly influence insurance policy costs and, more indirectly, how customers view the reputation of these rated companies.
It is great news for consumers to see that this market combines insurance and banking to offer more choice of financing. Stress tests have so far proved that the market has enough resilience to withstand more competition. Yet, new entrants and new products will put a strain upon revenue streams and profit margins.
Research indicates that the opening of the EU financial markets, and the impact of e-banking on traditional bank business lines, will cause likely profit margin erosion. These range from savings/deposits, mortgages, mutual funds and on brokerage. The different risk and business profiles of European banks make it hard to derive general estimates of this impact. Nevertheless, a fall in profitability from margin erosion has been suggested in the range of fi10 % to fi25 % for most banks.7 Banks would do well to assess their risk profiles in response to the changing market drivers.
Another issue is how the broad spectrum of banks, insurance companies and finance houses can be strongly monitored in the market by regulators who traditionally concentrate on banks. The FSA and Basel II are well geared to supervise banks offering traditional products, but they may be less prepared for non-banks providing the same banking products.
The Basel Committee has had to adopt a wider context of what is a bank and what is not. Furthermore, it took a narrow view of banking risk as a combination of the three factors – market, credit and operational risk. This is often too limited and we should consider in addition:
structural risks
strategic risks
reputational risks.
It may appear that these Basel pillars are independent and stand alone. This is the concept of the risk silos. Basel II concentrates on the three types of risk – credit, market and operational risk. Investors could be led to believe that these are the major risk types, and the only ones that matter. Or worse, these are the only business risks that exist.
Banks may feel that risk is not contagious so long as risks are hedged between its divisions, i.e. risk localisation or damage control. But, sources of risk are related and interlinked, and a culture of lax risk awareness can be pervasive throughout the entire bank. Some banks have been more eager to adopt an enterprise risk management view.
This wider risk view permits the integration of risk management across silos to protect businesses adequately. Basel II recognises this principle and goes part way in linking the pillars in a mutually supportive fashion. Basel links the Three Pillars together, partly with supervisory visits and the imposition of regulatory capital. The explicit Basel II doctrine is that you buy all Three Pillars together in a job-lot; you cannot choose not to comply with any one of the Pillars.
The Basel II major progress has been to integrate some of the split risk silos. It will combine market, credit and operational risk within the combined Basel II operating framework. That is not to say that Basel II has its limits or its detractors.
Instruments such as popularly traded bonds will have a credit rating; other obscure bonds may not. There is a default bond rating, and if the bond is inherently risky or unsafe, then it may not benefit the bank trader to get the bond rated especially if the default rating is more lenient than a fair rating. This is not likely to be a loop-hole that will be closed as it is unlikely that any regulator can force all banks to get external credit ratings for their entire bond portfolio. Leeway for local supervisor judgement and initiative will continue to exist.
One factor also lies in the self-certification of risk. Banks at the outset will be presenting their validated risk management models. They know that they will receive regulatory benefits if they can present a good model. It is not in the interests to be forthright with regulators to admit that they have a bad risk management system. Banks are given regulatory capital incentives to validate their risk management models, even when these embed realistic assumptions and inherent weaknesses.
Regulators have to establish consistent standards for comparing across banks and across risk management models. Otherwise, banks will win with the greatest presentations and “sales job” on the regulators. There will be a learning curve for both sides as the banks try to develop ever more sophisticated models, while the regulators gather enough survey data to sniff out who has developed good risk management practices and models. Conversely, this will also lead the supervisors to deduce what constitutes a poor model and risk management practice for Basel II.

Cost-benefits under basel

Banks and funs should already be developing more sophisticated risk analysis and more effective risk managemet. Creating risk profiles for the bank’s counter-parties in the manner of a murder investigation may sound sinister. This process operates within CRM (credit risk management) where risk probabilities, default exposures and customers’ records are logged. A detailed risk map of the customer’s current risk position, plus probabilistic directions, should be drafted for banks.
Business counter-party profiling takes in the whole range of risk appetites, from the conservative to the wildly speculative. Another CRM (customer relationship management) or a detailed KYC (know-your-customer) process will further spotlight the customer’s track performance. Basel II offers incentives for identifying losses and knowing your wise owl to the thieving magpie. Profiling of past risk events will form part of the loss database under Basel II to offer forecasting potential. This is similar to the VaR principle of using a historic dataset to predict the future. The Basel II Accord assumes that in operational risk, past errors and losses can be a guide to the future using the loss database. History repeats itself.
No standard set of business scenarios will fit the bill for any one institution. There will be different reasons why banks lose money. Furthermore, there will most likely be different categorisation money for the same case of why a bank lost. Standardisation will be tough to enforce across all banks, but the regulators will try to advise.
Compliance with regulation has now become more worthwhile. Basel estimates a 6 % drop in capital reserves for a large EU bank that wishes to manage its credit risk at the advanced AIRB level. A similar large EU bank aiming to achieve the lower standardised level on its core portfolios will most likely pay an additional 6 % capital charge.
Nevertheless, there will be some groups who will feel aggrieved that Basel II punishes them unfairly. For example, the EU leasing industry is probably faced with a 6 % capital requirement, derived from a gamma (fi) risk weight of 75 % multiplied by the 8 % capital ratio. The Basel II documentation implies a probability of default (PD) in the 5 % to 25 % region, which is particularly high. The empirical research by the leasing industry indicates that the PD is realistically nearer 3 %.
This is because physical collateral assets such as real estate, cars, trucks and plant machinery have a long-established time-series for developing financial control skills. Understanding of the specific industrial sector, plus the option for securing the lessor’s assets through repossession, means that default risk is low. External banking regulators have given little consideration for these risk mitigation factors, so the leasing industry becomes harshly treated.
The regulator’s seal of good housekeeping is worth winning under the new rules. The Basel II Accord recognises that levels of risk management skills should rise commensurately with lowering capital reserve limits as an encouragement. Fines and punishment of higher capital limits rise to the tipping point of where the pain becomes overbearing. Thus, the probability of being detected by better supervision and monitoring, together with the financial fines impact, make compliance an activity that creates return on investment.
Basel II has to be well designed for every bank so that regulatory capital will be commensurate with their risks. The worst-case scenario is that Basel II will misallocate capital and increase regulatory reporting constraints. Market risk and credit risk may demand more regulatory capital, but more administrative aggravation will hinder current business lines within some banks. Local supervisors would have to be more cognisant of specific industrial needs before applying capital charges in full.
Basel II rules will be applied in the UK by the FSA. There will be some input from the European Commission in Brussels. Some quarters have argued for an EU “super regulator” to coordinate the migration towards Basel II and to standardise EU standards for open financial markets. It would be desirable to have an effective form of Basel II coordination and supervision to monitor the complex migration process. This financial super-cop is unlikely to come about soon given the political and economic diversity within the EU, and the potential conflict between the numerous stakeholder groups.
The USA prefers to adopt a more laissez-faire attitude, where only their globally active major banks will be in the vanguard of Basel II adoption. These top 20 US international banks will have to comply with Basel II with the rest of the European rivals, but not the US domestic banks.
The FSA and SEC can move around banks during supervisory visits with a check-list for Basel II framework and other compliance controls. These have performance bands based upon aggregate data for similar banks in their banking sector. It is rather akin to the IRS or Inland Revenue tax authorities audit checks. A potential disadvantage of this check-list method is that financial supervisors may have less time to evaluate the banks’ financial modelling thoroughly. Just ticking off a check-list makes it simpler to hide errors and pass off riskier banks with advanced IRB and AMA risk management certification.

Parachuting in the experts

The mainstream train of building investment expertise in the emerging markets rests on the twin tracks of speed and economy. Yet, predicting major market and political movements cannot be built upon expert local knowledge after two days at the airport Hilton hotel. The changes just after the army onslaught on civilians in Beijing’s Tien An Men Square or the events following Gorbachov’s fall from power in 1990, or any Latin American putsch cannot be evaluated by an armchair expert who is in the country on a whistle-stop tour. This cannot be cost-effective in the long run as the local knowledge gained is superficial and the chances of committing market mistakes are commensurately higher.
A real-life view of handling risk means messy problems – and that requires managing operational risk effectively. Many companies are poorly structured to handle operational risk overseas; in fact, they behave more like risk-ignorant investors.