Risk Measurement – Traditional Banks vs Investment Banks

What should be the basis of measurement? Should we base it on the volatility of the mark-to-market value of a given portfolio, or else in terms of net income volatility? Before we try to answer the question it is important to appreciate that the approaches that banks take for a specific risk measurement differ from that of investment management companies in their approach to the identical risk. 

 

Before moving on to the aspect of measurement itself, we will take a closer look at the investment portfolio structure and activities of a large investment management company. They carry large dollar and yen fixed income portfolios; and under them we find investments in Credit Card receivables, Reverse Repos, Euro/dollar deposits and Mortgage-backed Securities, among others. They also usually carry Collateralized Mortgage Obligations with fixed and floating rates linked to such indexes as LIBOR of 1 month, 3 months, 6 moths, 1 year etc.,  Constant Maturity Treasury Rates of 1, 3 and 5 years respectively, Prime Rate and 11th District Cost of Funds Indexes. The reason for tying up to many indices is that some indexes yield better results when applied over  fluctuations in interest rates over longer periods while some give more accurate results over the short term. LIBOR is an index for all seasons, but is popularly used as an excellent measure specifically for monitoring even the very short term fluctuations.

 

Further, we observe a striking similarity between the formats of the balance sheets of banks, and large investment fund management companies. Fund management companies invest deposits in ways that maximize benefits to their shareholders.

 

However, banks and investment fund management companies do not see eye-to-eye on issues of usage of some other types of measurement tools. For instance, while Income Simulation and Gap Analysis (to a lesser extent) are used extensively by the banking industry as two major tools for monitoring risk management, the fund managers simply leave them aside. Main reasons for disagreements are that unlike the banks that have for centuries been highly influenced by the accounting profession, investment companies have operated very much more independently. In evaluating Risk Limit, investment companies/Banks match risk to a specific portfolio, while in traditional Performance Measurement, a total return above the base portfolio is considered a good performance.

 

Fund Managers attach so much importance to the specific indices used for the measurement of risks, that they make it a point to name the specific index used when communicating their risk limits to shareholders and depositors.

 

It is interesting to note though, that most fund managers seem to be not particularly interested in measuring their net income. The general argument adduced for this stand is that income simulation does not improve their position of risk/return performance.

 

But then, why is the banking sector so bent on the use of this net simulation index for communicating risk to their shareholders?

(a)     For one thing, the banking industry for centuries have been covering both risk and return when communicating with their shareholders on net income. For instance, Bankers Trust (created by a consortium of banks to provide trust company services) and JP Morgan have since become highly trading oriented that net income forecasts have no significance for them. But, by and large, banks continue to communicate with their shareholders using the language of mark-to-market and net income.

 

(b)     Net income of their respective branches as per financial accounts forms the basis for rewarding many branch managers. They find net income far simpler to understand and work with than the total return on a given portfolio for assessing branch performances. Further, banks have problems getting estimates of market values for a greater part of their portfolios.

 

It is obvious that large banks will continue to depend on net income and other financial accounting-based concepts as a supplement for their market-based risk measures for many more years to come. However, a gradual decline is certainly visible in their total dependence on net income-based risk measures. The current trends for large banks may be summarized thus:

 

  • Concepts of financial accounting-based net income risk limits and market-based risk limits continue to be employed for evaluating total institution risk management and ALCO portfolio.
  • Mark-to-market methodology remains the standards for transfer pricing of book and trading activities.
  • At individual business and branch levels, financial accounting-based net income measures remain the standard.

 

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