Risk management in banks, while clearly important, is complicated by the very nature of banks and the types of risks that they face. The Dodd–Frank Act, introduced as a consequence of the GFC, focuses on ending the concept of “too big to fail” and taxpayer-funded bailouts. If revenues fall to $20m in the current year, the activity will be deemed unprofitable according to shareholder standards, even if it has a positive return. 2, pp. CB Insights (2016), “The global Fintech report: 2016 in review”, available at: www.cbinsights.com/research-fintech-2016-report (accessed 28 March 2017). Given the need for risk-taking and the importance of risk management by banks and financial institutions, in the aftermath of the GFC, regulatory authorities have introduced or strengthened regulations that focus on the risk borne by these institutions, and the management of these risks. Indeed, risk-taking in itself is not inherently a negative activity. Naturally, by making use of this concept, our proposed framework inherits the shortcomings of the VaR concept. We propose a simple simulation-based method to estimate the economic capital. Another point of view that leads to the same conclusion is that corrective action in banks is often undertaken when they either under-perform compared to peers or are out of budget. Operational risk appeared as a separate risk type with explicit capital requirement in the Basel II framework in 2006. (1999) on definitions and methods for measurement of market risk. The capital asset pricing model (CAPM) can be used to easily estimate the COE of a firm. Furthermore, ABN AMRO was acquired by RBS in 2007 and after the GFC of 2008, RBS had to be bailed out by the British Government, and ABN AMRO was nationalized by the Dutch Government. Slywotzky, A. and Drzik, J. 179-200. (2014), “Governance, risk management, and risk-taking in banks”, Technical Report, National Bureau of Economic Research. Noonan (2016) reports that the growth of Fintech firms is estimated to spur a cut in almost two million banking jobs. Definition and concept . There exist few methods in the academic literature for the estimation of economic capital for business risk. We define strategic risk as the existing or future threat to the banks results or equity resulting from failure to (fully) anticipate changes in the environment and/or from incorrect strategic decisions. De Nederlandsche Bank (2016), “Technological innovation and the Dutch financial sector”, available at: www.dnb.nl/en/binaries/Themaonderzoek%20%20uktcm47-336322.PDF (accessed 20 March 2017). Sample Usage: An analysis of the organization’s strategic risk considered threats to carrying out its essential mission functions. 3 Risk appetite:3 The aggregate level and types of risk a financial institution is willing to assume within its risk capacity to achieve its strategic objectives and business plan. We model the net income plus impairment as a Brownian motion and use maximum likelihood estimation to determine its drift and volatility. In Tables AI and AII, we show the current definitions that the banks operating in The Netherlands adopt for strategic or business risk. The 99.95 per cent upper limit of this distribution is the VaR indicated with the red line. (2005), Countering the Biggest Risk of All, Harvard Business Review, MA. The paper postulates that the economic capital for a bank’s strategic risk should be estimated using the cost of equity as the profitability threshold, rather than zero and develops a simulation-based framework to estimate economic capital. Therefore, banks use different models and processes in their internal risk assessment (Aas and Puccetti, 2014). Risk management is a very important topic in both Strategic Management and Operations Management. competitors that enter the market or changing customer demand). CONTRIBUTE This form of risk is typically termed as strategic or business risk. However, the statement: “[…] the risk that earnings will fall below the fixed cost base, due to changes in margins and volumes”, more or less equals the strategic risk definition of Deutsche Bank and ING. In our study, we use interviews with industry experts to help in the formulation of the definition of strategic risk. The capital requirements prescribed in the Basel III framework refer to the economic capital that banks need to hold. There are a couple of things there, first and foremost it’s external to the organisation so things around WH&S and fraud and all those things don’t get a … Noonan, L. (2016), “Growth of Fintech forecast to spur almost 2m banking job cuts”, Financial Times, available at: www.ft.com/content/e00f8884-f65c-11e5-96db-fc683b5e52db, Philippon, T. (2016), “The Fintech opportunity”, Working Paper 22476, National Bureau of Economic Research available at: www.nber.org/papers/w22476. Energy Risk Commodity Rankings the biggest survey in the global commodity derivatives market to rank dealers, brokers and research providers. All rights reserved. Not all risks will have an equal impact on the business. When only the income growth, or the drift parameter increases the VaR decreases. Basel Regulatory Framework; Volcker Rule; Education, Training, and Assistance ... many firms have forgotten the second part of that definition. Measuring strategic risk, however, is not straightforward, as strategic risk has to be measured by observing deviations from the strategy formulated by the board (McConnell, 2012). Motivated by the significance of the threat posed by strategic risk in banks, the increased prevalence of strategic risk under current economic conditions, the scarcity of the coverage of strategic risk in the literature, and the increased importance of economic capital in the wake of the Basel III framework, this paper focuses on the quantification of a bank’s exposure to strategic risk. Gorton, G. and Metrick, A. Business risk is defined as the risk of financial loss due to changes in the competitive environment, or the extent to which the organization could adapt to these changes in a timely manner. Furthermore, ABN AMRO release information about their economic capital for strategic risk in their annual statements which we use to measure the performance of our framework. The US Government had to bailout AIG and General Motors after the events of the GFC. De Nederlandsche Bank (2016) focuses on the impact of Fintechs on banks operating in The Netherlands. We use 0.9995 as the value of α. Published by Infopro Digital Services Limited, 133 Houndsditch, London, EC3A 7BX. A firm’s strategic initiative usually has a horizon of three to five years, and we can run the simulation for a time frame that suits our needs. Printing this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/, If you would like to purchase additional rights please email [email protected], You may share this content using our article tools. For assistance please visit our Help Centre. Van Lanschot uses the terms business and strategic risk interchangeably in the annual report, The risk that strategic objectives are not achieved due to the company’s lack of response or inadequate or late response to changes in the environment and the business climate, Strategic risk arises from strategic decisions that fail to reflect the operating environment, or which do not take adequate account of execution challenges. To identify and deal with weak banks, they provide guidelines to the supervisory community in which they provide symptoms and causes of bank problems. Underlying profit, equity amount, return on equity and the loan impairments are noted in Table II. This might be actually attributed to better internal processes or a better economic condition that resulted in fewer defaults. Doff (2008) reports three commonly used methods to calculate the economic capital for strategic risk – analogue company approach/peer group analysis, statistical analysis and scenario analysis – based on the author’s own experience with banks. This definition includes legal risk, but excludes strategic and reputational risk_ BCBS adds standardised approach and internal model approach for market risk. 19 No. McKinsey (2015) assesses the profitability of banks by comparing the return on equity (ROE), defined as net income after taxes over the shareholders equity, with the cost of equity (COE), defined as the shareholders’ minimum required ROE. Basel Committee on Banking Supervision (2011), “Principles for the sound management of operational risk”, Technical Report, Bank for International Settlements. The density of the economic capital is different from when the limit was assumed to be constant, a logical result as a higher limit will result in a larger economic capital. The nature : Wide range of definition, therefore hard to identify and assess, ... •Calculation and planning (Basel II) •Risk transfer : Insurance แนวปฏิบัติ ธปท. This framework is generalizable and makes use of widely accepted and used practices in banks, making it readily implementable in practice. A Shapiro–Wilks test concluded that the underlying distribution can be accepted as a normal distribution. Such a framework could prove especially valuable given that the capital requirement regulations in Basel III will soon go into effect. 693-715. To test the effect of a changing COE over time, the simulation will be adapted and allow the profitability limit to increase over time. These banks include ABN AMRO, ING, Binckbank, Deutsche Bank, Rabobank, Van Lanschot, SNS, NIBC and RBS. Purpose: Basel III regulations require banks to protect themselves against strategic risk. In other words, these projects or strategies will lead to higher incomes as well as a higher volatility, but they are more sustainable because the decrease the VaR. Purpose: Basel III regulations require banks to protect themselves against strategic risk. The GFC led to the collapse of several banks worldwide. These actions and unprecedented levels of risk-taking led to the Global Financial Crisis (GFC) of 2007, the worst global crisis since the Great Depression (Gorton and Metrick, 2012). Strangle to resuscitate: evidence from India. These bailouts had to be funded by taxpayers. Risk management is a process of thinking systematically about all possible risks, problems or disasters before they happen and setting up procedures that will avoid the risk, or minimize its impact, or cope with its impact. Another definition of strategic risk is explained in terms of the Basel II regulation in the financial services sector. 26 No. Andrew Blau: Strategic risks are those that threaten to disrupt the assumptions at the core of an organization’s strategy. To estimate how a change in the policy can affect its requirement of economic capital for strategic risk, we do sensitivity tests on the ABN AMRO data. Purpose: Basel III regulations require banks to protect themselves against strategic risk. McConnell, P. (2013), “Strategic risk: the beanstalk syndrome”, Journal of Risk Management in Financial Institutions, Vol. For example, the recent penalty imposed by the US Justice Department on Deutsche Bank AG can be seen as a strategic risk, as it affects brand value and its income will need to be adjusted to estimate their economic capital requirements. You may share this content using our article tools. To measure strategic risk, we first propose a comprehensive definition, based on the literature, and interviews with some senior executives in Dutch banks. jeopardise achievement of strategic objectives; are created by, and inherent in, a firm’s choice of strategy and the plan to. As Table III shows, the equity can be represented as a linear trend. We try to estimate the cost of equity using different values of β that correspond to comparable banks. Economic capital for strategic risk can be estimated from the income statement of a firm, as the strategy of the firm will affect its profitability in a changing business environment. The method proposed in Chaffai and Dietsch (2015) is certainly sophisticated but requires computation of the efficient frontier and the directional distance function. All businesses need to take on some level of risk to grow and remain competitive. Basel Committee on Banking Supervision (2009), “Range of practices and issues in economic capital frame- works”, Technical Report, Bank for International Settlements. Basel Committee on Banking Supervision (2009) defines business risk as the risk that volumes may decline or margins may shrink, with no opportunity to offset the revenue declines with a reduction in costs. They’re often hard to spot and hard to manage. What’s so special about time series momentum? Deutsche Bank states The most material aspect of Business Risk is “Strategic Risk”, which represents the risk of suffering unexpected operating losses due to decreases in operating revenues which cannot be compensated by cost reductions within the respective time horizon” (Deutsche Bank, 2015, p. 267). Two major items that the net income should be adjusted for are the impairment charges and the restructuring costs. The freedom afforded to banks and financial institutions with the deregulation will again require the formulation of new strategies, thereby increasing the level of both strategic positioning risk and strategic execution risk. Energy Risk Asia Awards 2021 submissions are now open! BinckBank makes great efforts and substantial investments in its ICT platform and its products and services in order to attract new customers and retain existing customers. In one scenario, the required economic capital outlay will increase, and decrease in the other. The strategic risk faced by banks has gained prominence in the aftermath of the financial crisis, with the Basel III Accords identifying strategic risk as a potentially significant risk and requiring that banks hold capital buffers, or economic capital to mitigate against strategic risk. For management 16, pp. 225-246. https://doi.org/10.1108/JRF-11-2016-0142. To estimate the future net income, we use a stochastic process following the model of Böocker (2008). Each simulation run of the Brownian motion represents a different market scenario and the economic capital outlay is different for each. Under Basel III regulations, banks must calculate operational risk capital (ORC) using the standardized measurement approach. The ES can now be easily calculated as well: In this section, we apply the framework described in the previous sections to estimate the economic capital for strategic risk for a multinational bank. This makes a strong case for using ABN AMRO as a case study to show how our framework can be applied to estimate economic capital for strategic risk. We will first discuss the two extreme cases shown as red lines in Figures 5 and 6 – one where the income grows, but the volatility does not, and the other where the income volatility increases, but the growth does not. As mentioned in the introduction, banks face many kinds of risks usually classified under credit risk, market risk, operational risk and strategic or business risk. Abn Amro does not mention strategic risk as part of business risk. This means that the firm should choose projects and strategies that correspond to Scenario 2. Specifically, we make two contributions. It does not introduce errors resulting from model selection, parameterizations or complex calculations. The following are a few types of strategic risks. What distinguishes risk-taking in banks from risk-taking in other types of firms is the fact that the failure of a bank, as a consequence of these risks, can have a systemic effect on the global economy, as demonstrated by the GFC of 2007. 317-333. Suppose that the firm wants to undergo a new strategic plan or execute a project within the current plan which could potentially change the income growth and volatility. The firm is less attractive to shareholders when the ROE is less than the COE. The COE equals the amount of equity of the firm times the required rate of return r which is calculated as: Building on existing literature by Slywotzky and Drzik (2005) and Doff (2008), annual statements from banks and our discussions with industry experts, we propose the following definition for strategic risk: The risk of decline in net income, below a set limit, due to unforeseeable changes in either revenues or fixed costs that are caused by external trends in the banks’ competitive environment or the extent to which the organization could timely adapt to these trends. Strategic risk is highly prevalent in current market conditions, with the entrance of online banks and Fintechs, and looming deregulations. Schroeck, G. (2002), Risk Management and Value Creation in Financial Institutions, John Wiley & Sons, Hoboken, Vol. Operational risk in the Basel framework •Definition: Operational riskis defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. One possible reason for the scarcity in the coverage of strategic risk could be that it has been considered as a part of operational risk, as in Schroeck (2002). The bailout was not limited to banks. We arrive at our proposed definition, presented in Section 3.1 by analyzing the definitions of strategic risk in the academic and regulatory literature as well as the definitions provided in the annual reports of banks. We want to note here that adjustment of income will be different for different banks. Deutsche Bank (2015), “Annual report 2014”, available at: https://annualreport.deutsche-bank.com/2014/ar/servicepages/welcome.html (accessed 8 September 2016). Competitive Risk. Income generating activities are: selling loans, origination, cash management, asset management, securities underwriting, payment services and client advisory services. Yet, despite its significance in the risk framework, strategic risk has received scarce coverage in the literature. For example, the profitability of a firm is affected when it pays fines or legal claims, but these have nothing to do with strategic risk, as defined in the previous section. Please email [email protected] for more information. You can join in the discussion by joining the community or logging in here.You can also find out more about Emerald Engage. The framework facilitates better strategic risk management, protecting banks from collapse and reducing the need for taxpayer-funded bailouts. 4, pp. Usually, no buffer is maintained when firms execute strategic plans. In addition to assessing economic capital requirements, the framework also allows a bank to evaluate the impact of selecting a risk appetite, and formulating a growth strategy on its economic capital requirements. For example, business risk measures the risk that a business may lose value because its customers sharply curtail their activities during a market down-turn or because a new entrant takes market share away from the bank. SNS and Rabobank do not allocate economic capital for strategic risk, whereas Van Lanschot does. This paper aims to provide a comprehensive and measurable definition of this risk and proposes a framework to estimate economic capital requirements. There are common themes in these definitions in that strategic risks are those risks that: Copyright Infopro Digital Limited. This risk increasingly extends beyond balance-sheet items to income generating activities, which are not attributable to position taking, credit losses or operational events. ... Basel Committee on Banking Supervision, 2004 . 3, pp. For example, business risk measures the risk that a business may lose … During our interviews with industry practitioners, we noticed that the methods used in estimating the economic capital for strategic risk are different. Lando, D. (2009), Credit Risk Modeling: Theory and Applications, Princeton University Press, Princeton. International Monetary Fund (2011), “Kingdom of The Netherlands - Netherlands: financial system stability assessment”, available at: www.imf.org/external/pubs/ft/scr/2011/cr11144.pdf (accessed 31 March 2017). Banks are facing higher levels of strategic risk in current market conditions, with the entrance of companies specializing in combining finance and technology (commonly referred to as Fintechs). This white paper discusses the potential impact of UMR on portfolios, profitability, strategy and resource. In Scenario 1, an increase in income growth also brings in an increase in income volatility that is much higher than the linear trend we identified. Density of economic capital with in- creasing COE, Relationship between growth and volatility yielding the same economic capital. Despite its significance, the coverage of strategic risk in the academic literature has been rather scarce. Financial 5. The Monte-Carlo simulation-based method proposed in Schroeck (2002), while similar to our proposed framework, relies on the selection of a suitable macro-economic model. Our motivation for focusing on the Dutch banking sector was discussed in Section 1. In McConnell (2012), the author argues that strategic risk is the greatest risk facing any firm. Our focus on Dutch banks stems from the Netherlands’ stature as a small bank-oriented country with a large dependence on banking institutions, and a financial sector dominated by systemically important institutions that operate in diverse domestic and international markets (International Monetary Fund, 2011). Is there anybody out there? A strategic risk to me is something that is external to the organisation that if it occurs forces a change in strategic direction of the organisation. Sign up today and get access to: © Infopro Digital Risk (IP) Limited (2020). Furthermore, McConnell (2013) examines the collapse of Lehman Brothers during the GFC and notes that risk management policies that ensure that taxpayers need not fund bailouts of institutions if/when strategies fail are needed. The strategic policy of a firm is bound to change its performance in the future. The author focuses on addressing business risk in a banking environment and examines situations in which economic capital is a suitable solution to absorb losses caused by strategic/business risk. This is equivalent to quantifying the impact of strategic positioning risk on economic capital requirements. However, “being profitable” is a broad statement and deserves more attention, as it can be interpreted in many ways. McConnell (2013) provides several examples that demonstrate how institutions with aggressive growth strategies failed to manage the inherent risks, highlighting the need for proper risk management policies, and the role of regulatory authorities in ensuring that these policies are in place. Banks equate operational risk to event risk, which Schroeck (2002) defines as losses due to process failures, systems failures, fraud, legal claims or external disruptions that are caused by a rare event. We also received feedback on whether a capital buffer is necessary for strategic risk. We illustrate the application of the developed framework with a case study, based on ABN AMRO (which had an Initial Public Offering in November 2015) in Section 4. Viewing strategic risk as an operational risk may be trivial, but it is vital in terms of implementation and the resources dedicated to it. Thus, a natural direction for future research would be an extension to the framework to explicitly evaluate the impact of strategic execution risk on economic capital requirements. Basel Committee on Banking Supervision (2015), “Guidelines for identifying and dealing with weak banks”, Technical Report, Bank for International Settlements. If you are a Risk.net subscriber you are entitled to 20% off your Risk books purchases. (2012), Credit Risk: Pricing, Measurement, and Management, Princeton University Press, Princeton. For the analysis, we assume that the β of ABN AMRO is 1.15 which yields the COE (r equity) to be e310m. This chapter provides an introduction to the concepts of strategic risk and strategic risk management (SRM). The net income can be modeled as: Figure 1 gives an idea on how this is calculated. In other words, there can be no real strategic management in financial services without risk management, hence my use of the term "strategic risk management." The author uses two determinants, “adaption to changes” and “competitive environment” from the definition to classify different combinations of adaption and environment into: low, medium or high business risk. The definition of channel check with examples. Volatility and the corresponding definition studied operating in the financial regulations during the GFC, regulatory started. Transfer can take place do not allocate economic capital requirements, a slightly higher Figure than our results... 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