1 Amsterdam 7 November, 2013 The importance of different perspectives and implicit assumptions in models Frans de Weert

2 Objectives Different perspectives to capital management The importance of models when managing capital The incentives of regulation and its impact on model optimization The self-fulfilling prophecy of models How to mitigate the self-fulfilling prophecy

3 Capital management has two primary objectives: optimise capital structure and optimise performance Optimise capital structureOptimise performance Fulfil regulatory requirements Satisfy stakeholder expectations Determine optimal level of debt financing Translate strategy into capital allocation Optimise economic profit per business line Evaluate performance per business line Make optimal corporate finance decisions Optimise capital allocation Value Optimal cost of capitalOptimal return on capital

4 Capital management is about how a bank manages its available capital against its required capital Equity Subordinated Debt Business AssetsLiabilities Available capital Required capital Capital management LendingDeposits Financial investments Wholesale funding

5 Several perspectives have to be taken into account when managing this relationship Regulatory Capital perspectives Worl d Capital management AccountingCorporate finance Risk

6 One capital model cannot capture all of these perspectives Technical provisions Interest change Regulatory capital 1 Economic (Market consistent) Capital perspectiveImpact X 1 Assumes that regulatory capital is calculated under Solvency I, that reserve adequacy surplusses are not taken into account, and that interest rate change does not influence the outcome of the test

7 That is why it is so important to understand the tolerance of each stakeholder towards the capital position Secured lenders Low (High tolerance) High (Low tolerance) Capital level Impact irrational behaviour Low High Unsecured lenders Policy holders Subordinated lenders Equity holders Capital tolerance versus impact of irrational behaviour = tolerance and impact shift due to nervousness

8 Nevertheless, models are crucial for getting a feel for (complicated) risks or ‘adding’ different risks Models can be quite powerful since they can make abstract risks concrete Once risks are concrete you can talk about them, manage them and capitalize for them Moreover, it enables you to weigh risks against opportunities

9 Moreover, economic capital models can help in comparing the performance of different businesses and can therefore be used to allocate capital Raroc Economic capital Cost of capital

10 Basel III forces banks to think about the size of their balance sheet Available Capital = Economic capital Safe assets Liabilities Long balance sheet model (Dutch Banks) Available Capital = Economic capital Risky assets Liabilities Short balance sheet model (US / Spanish banks)

11 Solvency I is effectively a non risk-based leverage ratio limit while Solvency II is purely a risk-based framework Solvency I Capital requirement is effectively determined by taking 4% of the technical provisions Because the ratio between capital and technical provisions determines the leverage ratio, Solvency I effectively is a leverage ratio limit of 25 Risks of asset investments are not taken into account when determining the capital requirement Capital requirement is effectively determined by taking 4% of the technical provisions Because the ratio between capital and technical provisions determines the leverage ratio, Solvency I effectively is a leverage ratio limit of 25 Risks of asset investments are not taken into account when determining the capital requirement Solvency II Solvency II takes a risk-based balance sheet approach to determine the capital requirement Market risks (e.g. interest rate, equity, spread risk), insurance risks and operational risks are all taken into account when determining the capital requirement Solvency II does not know a leverage ratio Solvency II takes a risk-based balance sheet approach to determine the capital requirement Market risks (e.g. interest rate, equity, spread risk), insurance risks and operational risks are all taken into account when determining the capital requirement Solvency II does not know a leverage ratio Incentive to invest technical provisions riskily Incentive to de-risk and leverage

12 Because of the incentives from regulation, banks and insurance companies optimize their balance sheets (including model assumptions) to generate the highest return on capital Banks and insurance companies try to maximize their return given a certain amount of equity Regulation determines how much capital certain assets consume The capital requirement is quite often based on model calculations If a bank or insurance company maximizes its return on capital given a certain amount of capital, it will optimize its business but also model assumptions

13 This results in a self-fulfilling prophecy where banks and insurance companies become dependent on the (implicit) assumptions in models Since the models are optimized to generate the highest return on capital, the capital requirement becomes dependent on the implicit model assumptions This results in a self-fulfilling prophecy where models are constantly optimized further to be able to do more of the same business This ultimately results in a negative feed-back loop where one becomes more and more dependent on the implicit model assumptions

14 Even though the effectiveness of bank responses to the credit crisis had nothing to do with the quality of the models Denial Example Lehman Brothers Citigroup Bank of America Merrill Lynch Ineffective response Catch a falling sword Just in time Exploit the crisis Quick to respond Position well for after crisis Surrender Barclays JP Morgan HSBC, BNP Paribas Goldman Sachs Example

15 There are various mitigating factors for the negative feedback loop Model developers highlight the main (implicit) assumption of the models and under which circumstances the model leads to bad decision making Senior management understands the key variables and assumptions of the models Senior management tries to take several perspectives into account for decision making and stimulates the use of several models instead of trying to incorporate everything in one model