SERIES: Your Perspective on Risk - Part 2: Risk Perception

Henrik Merkelsen from the Copenhagen Business School in Denmark provides a view into the usage of the word "risk" in contemporary English language.  I noted in Part 1 of this series that risks are managed according to cultural perceptions: If risk is described by a culture as a danger or hazard, the culture is risk-averse, and the management of an organization within that culture sees risk as something to be avoided or mitigated.

This is the second part of a series on differing perspectives of risk between and within cultures.  The posts in this series are based on a small section of my doctoral dissertation.* You can find Part 1 by scrolling down below this blog entry or clicking here.

Scenario - What do you see? 

What do you envision when you see read the following scenario?**  

Noah sits under a boulder that may (or may not) dislodge from a ledge above him. 

Do you see:

• That Noah was placed under a boulder?
• The boulder's potential to dislodge and fall on Noah?
• Noah places himself under a boulder?

Your answer to that question determines whether you have the tendencies to take risks or to avoid them.  Interestingly, your answer will also reflect the culture in which you matured.  If you manage risk capital in a company or if you regulate a certain industry, your viewpoints will show up in your capital requirements.

* Risk Culture and Its Influence on Firm Value and Performance [© Tara Heusé Skinner, 2016, International School of Management, Paris].
**Adapted from Merkelsen, H. (2011). The constitutive element of probabilistic agency in risk: a semantic analysis of risk, danger, chance, and hazard. Journal of Risk Research, 14(7), 881-897. 

SERIES: Your Perspective on Risk - Part 1: Risk in Cultural Context

This is the first in a series on differing perspectives of risk between and within cultures.  The next few posts are based on a small section of my doctoral dissertation:  Risk Culture and Its Influence on Firm Value and Performance [© Tara Heusé Skinner, 2016, International School of Management, Paris].  I've worked to take out "academic-ease" so it won't bore you to death.

The definition of risk is hotly debated in the academic literature (trust me). One of my favorite studies was performed by Henrik Merkelsen* (Copenhagen Business School, Denmark) who looked at the concept of risk within contemporary English language, noting that semantic distinctions of the word risk may be different in “other languages and historical epochs.” My doctoral thesis postulates (in part) that the meaning of risk is based on not only historical context and language but on cultural perceptions as well. 

Risk as “the uncertainty of possible outcomes” is the traditional and neutral definition (neither positive nor negative). But when you describe that outcome as “a situation or event where something of human value is at stake” as Merkelsen notes, risk translates to “chance” (a neutral and perhaps, positive term) or to “danger” or “hazard”—decisively negative terms.
In my research, I found that risks are managed according to cultural perceptions. If risk is described by a culture as a danger or hazard, the culture is risk-averse, and the management of an organization within that culture sees risk as something to be avoided or mitigated, not something to be capitalized on. Consequently, the regulators in a risk-averse culture will demand more capital held for a (seemingly imminent) negative event. 

How a culture perceives risk determines whether an organization in that culture is risk-averse or risk-taking, and whether its management holds (or is required to hold) capital aside or makes it work for them.

...Click here to continue to Part 2.   

*Merkelsen, H. (2011). The constitutive element of probabilistic agency in risk: a semantic analysis of risk, danger, chance, and hazard. Journal of Risk Research, 14(7), 881-897.

And You, Too, Credit Unions

With all of the fuss about risk-based capital in banks (Fuss = US Basel III rules and capital stress testing regimes [e.g., CCAR and DFAST] in the US, BCAR in Canada, and EBA EU-wide stress testing), we tend to exclude the credit union from any discussion of risk-based capital.

However, credit unions have their own set of capital adequacy regulations, the amendments to which have recently been finalized by the National Credit Union Administration (in the US). The amended capital adequacy rules will be effective on January 1, 2019 for “complex” credit unions (i.e., those with assets greater than US$100 million). 

Community Banks Take Note:  While some view credit unions as the enemy because their tax-exempt status gives them an edge over banks, banks aren't required to calculate risk-weighted assets or apply regulatory capital adjustments until their asset size exceeds US$500 million (US Basel III rules). 

A Suggestion for Credit Unions

The new regs for credit unions look suspiciously like Basel's Standardized Approach, so may I offer a suggestion?  2019 seems far away, but if you start now, you can take a bit of time to not only comply with the amended regulations but to also institute risk-based pricing into your credit portfolios.  Many of the smaller community banks were caught flat-footed when the US Basel III rules went into effect. The same thing doesn't have to happen to you if you start now.

In very broad terms, and from a lending perspective, this road map illustrates activities that can be undertaken now.  The plan here is to have a "dress rehearsal" of sorts a year before you have to go live with the amendments.

Part 702 Compliance and Credit Scoring Road Map

© Tara Heusé Skinner

With the institution of internal credit scorecards and risk-based pricing in addition to risk-based capital requirements, you should see positive cash flow on your compliance costs.  Ensure compliance on January 1, 2019, but ensure that you are also able to pass profits on to your members.    

Any Day Now...the Big Muddy and the Banking industry

When I was an undergrad at Nicholls State University a "few" years ago (honestly, it feels as if it were only a few years ago), I frequently met a friend for lunch between classes.  One day, her class ran overtime, so I met her at her classroom door as she and her fellow geology majors were abuzz with the topic of conversation that day.

What had them so excited?

Most of us at NSU were from the Southern United States, specifically, the most Southern part of Louisiana, near New Orleans.  We grew up in a culture rich with history and with much of our activities and economy defined by the water surrounding us.  In their geology class that day, the topic of discussion was the long-overdue course-correction of the Mississippi River.

According to the Science Education Resource Center at Carleton College (SERC), the Mississippi River stays put for about 1,000 years, then moves laterally across the Delta Region. The rub?  The current course (white line in the satellite photo) has been in place for over 1,300 years.

SERC says that the River deposits enough sediment in its thousand-year stay (hence, the name "Big Muddy") to make the Delta rise.  Once the Delta is significantly above sea level, the river channel will migrate to a shorter, more direct route (blue line) to the Gulf of Mexico. 

The geology students' excitement that day had to do with the course-correction itself.  I heard many of them say they wanted to be there the day it happened to see it first-hand.  The business majors among us were concerned about the New Orleans economy after that rather cataclysmic event, but the geologists simply said that New Orleans would still be a vibrant international port city - just a salt-water one.  This is truly a geologist's great adventure.

The Banking Industry

What does the River course correction have to do with the Banking industry?  A recent report by E&Y - "Rethinking Risk Management" - states that the demands of regulators and, in turn, the reaction of shareholders will change the current banking business model.  To me, it is exceedingly evident that the financial services industry business model will change--and change drastically.  I don't look at it with fear and trepidation; this is an adventure.  Like those geology students, I am excited about the change, and I want very much to be a part of that adventure.

Risk Capital and More Lessons from the Titanic

In last week's blog post, I summarized an illustration I use to explain the differences between Regulatory, Equity, and Risk (economic) Capital, equating each type of capital to the lifeboat capacity of the RMS Titanic in 1912.  

The ship was built to hold 64 large lifeboats carrying a total of over 4,000 people--more than enough as the ship itself could only house a maximum of 3,547 passengers and crew.

More than required...

Moreover, the British Board of Trade (the regulators) required that a ship of Titanic's size had to carry 16 lifeboats for 990 people.  Management (White Star Line) met the 16 lifeboat requirement and then some...the larger lifeboats aboard the Titanic could hold 70+ people each for a total of 1,178 ("equity capital").

...but less than necessary

Although equity capital exceeded regulatory capital in this case, "risk capital" fell short of the 2,224 passengers and crew on board.  As equity capital held should be equal to at least risk capital, would 32 lifeboats have saved all 2,224 aboard?**

Economic Capital Before the Financial Crisis

We see the problem for a naval disaster that occurred over 100 years ago.  What about the latest financial disaster from 2007-09?  If economic capital was truly in play pre-2007 crisis, why was there a crisis?

Economic Capital is the best estimate of required capital that banks use to manage their own risk; it is an internal measure, based on a bank's estimate of its own appetite for risk.  The conclusion, therefore, is that economic capital failed, not because it is a useless measure but because banks' conclusions about risk matched those of the White Star Line:  Risk of sinking is quite low when you are aboard the "Unsinkable."  



* Details from Wikipedia, see RMS Titanic article.
**Probably not.  Even though the lifeboats could have held 1,178, only 32% (710) of the passengers and crew survived.  That's a study in operational risk that I'll get to in a later post.  

Capital vs. Capital vs. Capital

When Economic (Risk) Capital was the talk of the financial services industry, I included a simplified explanation of it in my risk management course at the American Bankers Association's Stonier Graduate School of Banking. Subsequently, I wrote an article on it, entitled Risk capital and lessons from the Titanic, when I was with the Risk Research and Quantitative Solutions group at SAS Institute.  Thankfully, even after my departure from that organization, the article still lives in cyberspace, though my byline has been removed (and rightly so).  In summary:

• Equity Capital - the amount of operational capital (cash) that the management of a financial institution deems necessary to operate its business.
• Regulatory Capital - the amount of equity capital required of a financial institution by its regulator.
• Economic, or Risk, Capital - an estimate of the worst possible decline in the financial institution’s amount of capital at a specified confidence level, within a chosen time horizon, saving for a "rainy day."  It gives senior management insight into a worst-case scenario.

Ideally, financial institutions should hold equity capital of an amount equal to risk capital.  Setting capital aside, so to speak, for a very bad day.

In my course and in the SAS article, I equate three different types of capital to the lifeboat capacity on White Star Line's Best-in-Class (for 1912) luxury passenger ship, the RMS Titanic.  

Capital illustrated:

• The regulatory body for passenger ships in early 20th Century England was the Board of Trade.  It required that 10,000+ ton vessels such as the Titanic carry only 16 lifeboats with a capacity to hold 990 people.  In this case,
• "Regulatory Capital" = 990 
• The management of White Star Line made the decision to carry 16 lifeboats able to hold 1,178 people, more than what was required by the Board of Trade.  
• "Equity Capital" = 1,178  
• Risk capital, given the worst-case scenario:
• "Risk Capital" = 1316 passengers + 908 crew = 2,224

Uh oh.