Abstract
Purpose: Basel III regulations require banks to protect themselves against strategic risk. This paper provides a comprehensive and measurable definition of this risk and proposes a framework to estimate economic capital requirements. Design/methodology/approach: The paper studies the literature and solicits expert opinion in formulating a comprehensive and measur- able definition of strategic risk. 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. Findings: The framework closely matches the actual economic capital outlay for strategic risk from our case study of ABN AMRO. We show that a bank’s strategic growth plans can fall into one of two scenarios based on risk-return characteristics. In one scenario, the required economic capital outlay will increase, and decrease in the other. Practical implications: Our framework is generalizable and makes use of widely accepted and used practices in banks, making it readily implementable in practice. It does not introduce errors resulting from model selection, parameterizations, or complex calculations. Societal implications: Society would be worse off in the absence of banking and lending services. Banks need to take risks to grow and stay competitive. The framework facilitates better strategic risk management, protecting banks from collapse, and reducing the need for taxpayer-funded bailouts. Originality/value: The paper provides a measurable and practitioner-verified definition of strategic risk, and proposes a simple framework to estimate economic capital requirements, a crucial topic given the threats and increased levels of strategic risk facing banks.
Highlights
Banks and financial institutions provide a variety of essential services that are key to the functioning of the global economy
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
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 Global Financial Crisis (GFC) of 2007
Summary
Banks and financial institutions provide a variety of essential services that are key to the functioning of the global economy. Lending to less credit-worthy customers, securitizing and trading these mortgages were part of a flawed strategy by institutions such as the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, Lehman Brothers and AIG. 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). Stulz (2014) argues that while limiting the systemic risk a bank creates is important for society, there is no a priori reason that a bank that has less systemic risk is worth more for its shareholders. The emphasis lies in taking on appropriate levels of risk and managing these risks
Sign-in/Register to view highlights & summary Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a callDisclaimer: All third-party content on this website/platform is and will remain the property of their respective owners and is provided on "as is" basis without any warranties, express or implied. Use of third-party content does not indicate any affiliation, sponsorship with or endorsement by them. Any references to third-party content is to identify the corresponding services and shall be considered fair use under The CopyrightLaw.
