Forcing Banks to increase Capital is driving them to take on more risk, sowing the seeds of the next crises.

GARP (the Global Association of Risk Professionals) today forwarded members the following link to a Bloomberg report that notes the “Fed’s Bubble Busting in Junk Loans Seen Failing as Sales Surge” see: http://www.garp.org/risk-news-and-resources/risk-headlines/story.aspx?newsid=114766

While the article includes various explanations as to why Financial Institutions (FIs) are taking on highly risky assets at an alarming rate, and why regulators seem impotent to reign in this dangerous trend, one important underlying cause is not mentioned – the Capital Paradox.

Karamjeet Paul, in his important book ‘Managing Extreme Financial Risk’ describes the Capital Paradox thus:

“If (a Financial Institution) adds capital, then it needs to generate higher earnings to cover the cost of incremental capital. The quest for higher earnings requires the institution to take on more risk to generate these earnings, as risk management primarily drives the current revenue model. In turn, higher risk creates the need for more capital. Therefore, the industry’s dependency on increased capital to maintain the current revenue engine is not sustainable.” Chapter 11 at 11.2

In fact herein lies a dual paradox; since FI executives are measured by return on capital, increasing the capital drives, even licences, the executives to buy and invent more risky financial assets.

Regulators are driving FIs to increase their capital in order to strengthen their ability to survive the next crises, which will be driven by a tail-risk event (occurrence of a negative Black Swan event) a phenomenon Mr Paul calls an Unquantifiable Uncertainty.

Since Banks/FIs changed their revenue model from one based on intermediating loans to one of intermediating risk, they have become risk traders rather than lenders. Funding is provided by ‘the market’ so banks merely underwrite the investment risks, and then trade away risk they cannot afford to hold. This is the revenue model that led to the development of the subprime mortgage market and related complex products. In brief, FIs no longer invest in real businesses directly, they invest in financial instruments.

Unfortunately for the world at large FI Regulators still focus their post 2008 risk management strategies on Quantifiable Uncertainties; those uncertainties (risks) that can be quantified with 99% confidence by use of VaR (Value at Risk) models. Such models ignore the ‘outliers’, the risk instances that occur beyond the third standard deviation. FIs and Regulators are so star-struck by the precision of these models and the multiple academic degrees in quantum physics held by the builders of these models that they tend to forget that the models all contain one dangerous assumption.

The assumption that the future will resemble the past and nothing that has not occurred in the past will occur in the future; however Unknown Unknowns have occurred frequently in the past four decades with devastating financial impact globally.

In his book Karamjeet Paul offers a practical approach to managing an FI’s Tail Risk associated with Unquantifiable Uncertainty, which is well worth serious consideration.

As a reviewer of Mr Paul’s book notes on the jacket; “Managing Extreme Financial Risk should be required reading for regulators, board members, CEOs, and CFOs of large financial institutions.”

In closing it is depressing to think that the words of Henry Ford who said; “A Business that makes nothing but money is a poor kind of business,” so aptly describe the role adopted by too many of today’s global FIs. So many talented and dedicated individuals work hard in those FIs but essentially participate in producing nothing of value, nothing real.

BarrettWells