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Why Economic Capital Management Now?

Opening speech by Atsushi Miyanoya, at the BOJ workshop on Economic Capital Management, on July 11 and 12, 2007

September 14, 2007
Bank of Japan
Center for Advanced Financial Technology

The presentation material can be downloadedhere (fsc0707a1.pdf, 32KB).

Contents

Introduction

Good morning, ladies and gentlemen. My name is Atsushi Miyanoya, head of the Center for Advanced Financial Technology, Bank of Japan. At the beginning of the workshop, I would like to explain the importance of Economic Capital Management (ECM), following viewpoints required for performing ECM, and lastly challenges for Japanese financial institutions.

Growing importance of ECM

In recent years, there is a growing importance of ECM. I can point out three factors: (1)transition of regulatory framework from Basel I to Basel II, (2)progress of financial innovation, and (3)expanding scope of business in the finance industry.

First, with regard to transition to Basel II, I would like to pose a question, "Why capital is calledeconomic capital in the finance industry, while it is merely calledcapital in other industries?" This is because there is another concept of capital in the industry: "regulatory capital." In the finance industry, each bank's optimum capital adequacy ratio freely determined by the management to meet shareholders' interests does not necessarily ensure the soundness of financial system as a whole. Therefore, by regulation, banks have been required to retain minimum level of capital according to their asset size or risk amount, and this is the concept of "regulatory capital". Under Basel II framework, relationship between risks and regulatory capitals has become more minutely defined than before. Moreover, Basel II not only requires banks managements to hold minimum required capitals, but also has the procedure (pillar 2) for regulators to review banks' capitals in relation to "economic capitals," (freely determined by the management to ensure both efficiency and soundness of the bank). Basel II also has the framework of pillar 3, which utilizes market discipline instead of regulations in encouraging banks to further disclosure. In particular, it is a great change that under the framework of pillar 2, banks' managements are required not only to hold minimum level of capital, but are expected to be accountable on ECM. Such a new regulatory environment is one of the significant factors in provoking discussions on ECM.

With respect to progress of financial innovation, developments in information technology and financial engineering have made banks' risk management methods more sophisticated on one hand. On the other hand, however, financial innovation has made the life-cycle of financial products shorter, since existing products have become somewhat old-fashioned with the introduction of new products. To achieve higher profitability and survive under such severely competitive environment, continuous challenges by the banks such as providing services more efficiently and taking risks with more complex and intangible profiles are expected. Since risk money from institutional investors and hedge funds has rapidly increased and circulated throughout the world thanks to innovation, financial role-sharing between banks and such investors has become more influential to risk profiles and profitability of banks. Whether or not financial innovation generate continuous progress of financial markets depends on balancing the development of more sophisticated risk management with the development of larger and more complex risks. It is just like sustainable growth of the world economy needs well-balanced expansion of supply and demand. The history of mankind has proved that progress of technology did not automatically guarantee people's well-being, since it has sometimes generated conflicts, inequality, and social disorders, bringing misery and anguish among people. We need not only to encourage cultures leading technological developments but also to utilize the fruit of developments for enhancing peace and prosperity among the world. Such never-ending efforts to explore solutions and share ideas may sustain the true evolution of mankind. In the finance industry, I believe that bank management's role has become more important in sharing appropriate risk management framework and it's philosophy with various stakeholders, in line with the progress in financial innovation.

Thirdly, I would like to speak about the expanding scope of businesses in the finance industry. Presently, the world economy is in the phase of strong expansion, for the first time since 1970's. In the developed countries, strong investment demands, backed by ageing society, are seeking better opportunities to put their money around the world, while expanding emerging countries are making efforts to attract and utilize money from developed countries by improving their macro-economic conditions and infrastructures. Economic globalization brought changes in relative prices by generating price stability of labor-concentrated goods and price hikes of natural resources. Furthermore, solving environmental problems has become an important task for sustainable economic growth, and efforts are steadily made to solve these by utilizing market mechanism. All of these changes contribute to expanding the scope of financial businesses. If a bank can not effectively take new opportunities into its business, imputed loss of income may not remain marginal. It takes certain amount of costs for banks to improve their ECM framework and sufficiently prepare for new risk-taking activities. However, opportunity costs may be larger for banks that do not challenge and keep taking risks only in the limited areas.

The three factors I mentioned so far, the transition of regulatory environment, financial innovation, and expanding scope of financial businesses, do not stand independent, but are mutually influential. For example, expansion of financial business fronts encourages financial institutions to create new products or services, and then, such progress of financial innovation attracts new type of customers which in turn can lead again to further expanding the scope of financial businesses. Regulators have also changed their rule making policies to maintain positive feedback mechanism between financial innovations and expansion of businesses. The three factors will make further progresses, mutually influencing one another. I believe that ECM is one of the frameworks that can play a key role in bank management under such a dynamically changing environment.

Viewpoints required for performing ECM

Now, I would like to turn to the topic on viewpoints required for performing ECM. In order to perform effective ECM, banks should design the ECM framework from the following two points of view, (1) whether ECM functions as a tool for improving profitability and soundness of banks, (2) whether it functions as a tool of communication between banks' managements and their various stakeholders.

Regarding the first point, it can be broken down into three elements; (1) framework to identify precise measurement of risks, (2) device to improve profitability in relation to risks, and (3) device to secure sufficient capital in relation to risks.

First, identifying precise measurement of risks is a precondition for banks to make appropriate profit and maintain soundness. To measure risks, we have to evaluate intangible uncertainty and translate it into more tangible forms. Although quantitative evaluation methods such as VaR are generally used, entire risk measurement procedures including ideas of setting confidence level and utilizing stress-tests should be effectively designed and implemented.

Secondly, I would like to refer to the function as a tool of improving profitability in relation to risks. In ECM, profits/losses are evaluated by internal management accounting, rather than by official accounting. But financial products have peculiar features which generate difficulties for evaluation. For example, it is not clear how we would evaluate the changes in the value of distressed loans and unrealized profits/losses of non-marketable securities, not reflected in financial statements. This depends on how we evaluate expected return and volatility of invisible future cash flows. Since banks' balance sheets are mainly composed of financial assets and liabilities, the proposition that "No precise evaluation of risks, then no evaluation of returns" may be most suitable for finance industry. Furthermore, in assessing profitability in relation to risks, capital costs required by shareholders should also be taken into account. Banks' managements should challenge these difficulties, enhancing risk/return awareness throughout the bank by using segmental approaches such as performance by sectors, by regions, and by products if needed. I believe this is the quintessence of ECM and hence the core task of banks' managements.

Thirdly, ECM should function as a framework to check whether banks' challenges to improve profitability are met with sufficient amount of capital in relation to risk. If the management merely seeks to hold enough capital, they may take conservative approach such as holding risk-buffer as much as possible. The larger the capital, however, the more difficult to generate enough returns on capital. Therefore, it is critical for management to identify risks earlier and to adjust risk amount and capital flexibly, in other words, to react dynamically to maintain bank's soundness with smaller risk-buffer.

Besides the first viewpoint to improve profitability and soundness of banks, the second viewpoint necessary for ECM is whether ECM can function as a common communication tool between banks and various stakeholders. For example, shareholders' interests which prefer to maximize returns and regulators' interests which put emphasis on financial stability may not be consistent with one another. Thus, ECM plays an important role in providing objective information to various stakeholders, which in turn enhances balanced corporate governance between risk-taking and risk-controlling.

There seems to be, however, a trade-off relationship between improvement of risks/returns and enhancement of communication with stakeholders. Precise measurement of risks requires more complex and advanced techniques, while enhancing communication needs to identify the essence of risks in a simple way. In overcoming such trade-off relationship, however, banks may find new sources for profit-making. It is a prerequisite for banks to promptly satisfy various customer needs and to constantly make profits by translating complex risks into simpler forms which may become useful for business judgments and active dialogue with stakeholders.

I can explain the communication function of ECM in a parable. The earth is round, very large and complex, but if we use certain techniques such as projection method of Mercator, we can show it on one piece of paper. When using this method, although Greenland and Antarctic continent are much larger than the actual size, such a deforme is accepted in general. In ECM, we should make further continuous efforts in expressing risks clearly, and fostering active dialogue.

Challenges for Japanese Banks

In general, it is anticipated that ECM play the above-mentioned roles. For each bank, however, there is no common optimum form of ECM. Unique style of ECM should be explored by each bank based on its financial environment, management strategy, and so on. In particular, if bank's home country varies, there may be substantial differences in historical and social background of finance as well as banks' business models. Here, I would like to explain possible challenges for Japanese banks.

In comparison with major U.S. and European banks, Japanese banks have a clear feature to put greater emphasis on profit-making through long term relationships with borrower firms, so called "relationship banking." Main bank system is a typical form of the relationship banking in Japan. The system ceased functioning after the bust of economic bubble followed by structural changes of the economy, while it had effectively worked during developing period of Japanese economy. After prolonged process of resolving bad-loan problems, Japanese banks have just started to build new business models.

For instance, syndicated loans have been increasing for couple of these years, where credit risk has become widely shared by banks rather than solely borne by the main bank. It is not easy, however, to make drastic changes in the existing relationship between banks and firms since it had been well established as part of the Japan's social structure. Despite the rapid increases in loan syndications, the secondary trading market is still undergoing development stage where lending policies of Japanese banks remain to "originate and hold." The size of credit-default swap market is only a hundredth of that in U.S., though it has been rapidly expanding. Thus, credit risk transfer is still in a cradle period in Japan.

Meanwhile, U.S. and European leading banks have substantially changed their business models reacting to environmental changes such as financial innovations and rapid emergence of new financial players such as hedge funds. Therefore, main issues to be solved through ECM could be different between Japanese banks and Western banks. For example, most important tasks for western banks including "lower liquidity of credit related market" and "increase in operational risks associated with rapid growth of derivatives market" are not necessarily the top priority for Japanese banks. Instead, Japanese banks' business models to take credit risk exposure longer in the relationship with borrower firms generated unique problems to evaluate risk-return situations.

First, transaction in credit related market is not active in Japan, thus making cases for banks to utilize prices in the market for credit evaluation very limited. This may cause improper pricing when originating loans, and delay recognition of decrease in loan value after origination. Therefore, I believe that establishment of management system to minimize such risks is one of the major challenges for Japanese banks on ECM.

Secondly, actual term of bank loans tend to be longer since Japanese banks put emphasis on maintaining relationship with borrower firms, and are reluctant to sell the loans before maturity. Recently, leading Japanese banks have adopted the method of active loan portfolio management, but are still in the elementary stage. As a result, major banks remain to extend large amount of loans to blue-chip companies. On the other hand, regional banks mainly tackle to increase loan volumes in order to improve their loan/deposit ratios, although loan demands are weak in local economy. Thus, there are substantial rooms for them to cope with risk of credit concentration by name or by geography.

If Japanese banks face such concentration of credit risks, and if the pace of adjustment takes time due to long-term relation with the borrower firms, it would be meaningful for Japanese banks to recognize and assess measurable risks by standardized methods such as "unexpected risks with 1 year holding period," and un-measurable risks by such methods; e.g. risks of increasing loan exposures of main banks under economic stagnation.

Thirdly, Japanese banks usually hold certain amount of stocks issued by borrower firms based on their strategies to build long term relation. Banks hold stocks for long period of time as stable shareholders, and absorb the fluctuation of the firm's value. Instead, it is said that banks can take advantages in gaining not only equity investment profit but also other fruits of businesses from firms such as fee-businesses. As a result, however, Japanese banks bear large amount of risks caused by volatility of equity prices. When the economy stagnates, both equity prices and loan values are likely to decrease simultaneously. Besides, it is almost impossible for banks to reduce the amount of strategic stock-holdings in response to market fluctuation, since such stock-holdings of borrower firms can not be sold without the consent of the firms. Therefore, Japanese banks need to evaluate the risks of strategic holdings of borrower stocks, and taking such limitation into account, should review overall profits in comparison to risk evaluation. I believe this is another important theme for Japanese banks with regards to ECM.

In the Japanese banks' business model based on long-term relation with customers, it is not so easy to objectively divide transactions with customers into profitable and non profitable parts. But Japanese banks have just started to change business mode from "defensive" to "offensive" approach including the re-expansion of their international businesses. I think it is a critical stage for Japanese banks in enhancing competitiveness in global financial markets to steadily evaluate profitability in relation to risks by using the framework of ECM.

Conclusion

Referring to the case of Japanese banks, I explained that the style of ECM may vary according to each bank, reflecting different business models and characters of their stakeholders. It is, however, essential that banks utilize ECM not only as a management framework applicable to existing business models, but also as a proactive communication device that sends information to various stakeholders. Banks' managements should be forward-looking at possible changes in global economy and trends of financial/IT innovation, pay due attention to important points unnoticed or overlooked by shareholders, and engage in active dialogue with regulators on changes in their profit making (risk taking) models. It is significantly important for banks' managements to clearly express their visions and philosophy based on solid risk/return analysis by using common language of ECM, which enhances mutual communication with stakeholders. I think such challenges generate energies to make further progress in banks' business models.

Whether prolonged growth of world economy further continues or not depends on whether we can prevent imbalances from accumulating. In the finance area, it is very important for banks to maintain balances between risk-taking activities and corporate governance. ECM has great potential in securing sound development process among business models, financial markets and regulations. At the same time, however, it is a big challenge for banks to foster dialogue and explain their unique and complex risk management situations using common language to stakeholders. There are many hurdles to be cleared technically.

The motivation for holding this workshop is to explore various possibilities of ECM and to share knowledge with wide range of people, including Japanese and foreign bankers, bank supervisors, and other financial experts. I hope that all the speakers as well as floor attendants would try to be franc with one another, activating discussions on possibilities and challenges of ECM based on your ideas and experiences in this workshop.

Thank you for your attention.