RISK MINDS USA
Setting Risk Appetite in the New Regulatory
Environment Linking Strategy, Risk and Capital
Structure ©
Joseph V. Rizzi
June 15, 2011
The views expressed are the author’s, and do not reflect those of CapGen Financial
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1
Introduction
2
Risk Appetite
3
Capital Structure
4
Conclusions
1. INTRODUCTION
3
Introduction
(Risk Appetite as a Process…
 Need to incorporate capital structure and risk considerations
as an input versus consequence of strategy
 Capital as cost of risk
 Return as cost of capital
 Risk as cost of return
 Risk appetite links strategy, risk and capital –represents total
risk exposure an organization is willing (and capable?) to
accept and retain in pursuit of its strategy
… Not a Number)
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Introduction (cont)
Volatility
(Once set…
Strategic Capital
Budgeting (CEO)
Liquidity
Capital Structure
CFO
Capabilities
Risk Appetite
Return
Risk
Management
(CRO)
Opportunities
Correlations
Performance
External Stakeholders
Shareholders
Risk/Return
Regulators
Governance
Rating Agencies
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…Risk appetite is continuously monitored and revised)
Introduction (cont)
(Governance Puzzle: How to resist excessive risk
Governance
Monitoring and
Rebalancing
Investment Strategy
And Risk Appetite
Performance
(Asymmetric information)
…taking in benign markets)
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CAPGEN FINANCIAL
2. RISK APPETITE
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(Return on equity value illusion…
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…Confusing key performance Indicators with value drivers)
Implications of Risk Appetite Charges
(Not all Risk is the Same…
Capital Requirement
Return
B
A
Efficient Frontier (Beta)
D
C
Rf
E
A – Current
B – Target
D – C = Capital Need to Support Target
EF = Increased Risk Appetite
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F
Risk
…Cost of Risk is Capital)
(High Returns Evidence of Skill……
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… Or Extreme Risk Taking?)
Problem – Procyclical Risk Appetite
(Risk Appetite Changes are Prone to Behavior Bias and Drift…
High
Low Risk
Appetite
Bull
Market State
Bear
Strong
2003/06
2007
2008
2009
Capital
Weak
Risk
Reinforcement
•Budgets and Bonuses - KillerBs
hard to recognize risk if you are paid not to do so
•Preoccupation with Growth – Barclays?
•Herding
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… and vary over time depending on wealth)
3. CAPITAL STRUCTURE
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Capital Structure – Integration of Capital
and Risk Management
Risk never disappears….
Mix of securities (Capital Structure) and Risk Management Products

Capital structure optimization is the purpose of risk management – 2 sides of same
coin
 Risk management is capital structure in disguise
 Risk management as synthetic or substitute equity
 Approaches
 Risk transfer transfer (Cause)
 Risk Finance (Effect)
 Integration of corporate finance and risk management
 Cost/Benefit analysis regarding use of risk management or risk finance
 Issue is whether it is more efficient to (self insure) hold capital or to use risk
management to eliminate the risk cause
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---someone is always on the other side of the trade
Stakeholder Views of Capital Differ
Is the glass half full or half empty
Rating Agencies
 Capital focus is primarily on tangible equity
capital and capital replenishment capabilities.
Regulators
 Concern on through the cycle capital and
Shareholders
 Are focused on capital discipline and
buffers
allocation
Management
 Capital Returns and bonuses
… it depends on whether you are pouring or drinking
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Capital Guidelines
(How much is enough?…
S&P: RAC
Very strong
>15%
Strong
15/≤ X <10%
Adequate
10 ≤ X < 7%
Moderate
7% ≤ X < 5%
Weak
5% ≤ X < 3%
Very Weak
>3%
CAMELS – “C” and “A”:Classified Assets/T1 + ALL
1 - O ≤ X ≤ 25%
2 – 26%< X ≤ 40%
3 - 41% < X ≤ 80%
4 - 81% ≤ X ≤ 100%
5 - > 100
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CAPGEN FINANCIAL
…it depends
Scenarios: To Assess Possible Strategies
Against Capital Structure Robustness
(Can I survive and tolerate…..


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The upside (U) and
base (B) cases
generate excess capital
which points toward
shareholder
distributions
The downturn (D)
scenario suggests
possible changes in
risk appetite and the
development of
appropriate
contingency plans to
maintain ratios, sell
assets and raise
capital.
Forward looking Core Tier 1 development under alternative scenarios
(Stress testing)
Core Tier 1 Ratio
Financial policy
implications:
U
------------------------B
-------------------------
Return
Capital
Raise/release
Capital
Probably
Unlikely
May be
May be
Unlikely
Probably
D
T
…the worst plausible outcome?)
Decisions at Risk (DAR) Control Framework
(Who decides…
…And how do they decide?)
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Elements of Strategy Based Capital Structure Management
(Risk and capital as inputs into strategic planning….)
Choice of Markets with Attractive economics in
which the organization enjoys a competitive advantage
Strategy
Risk Appetite
Risk the organization is willing and able to accept in
pursuit of its strategy
Risk Assessment
Risks underwritten and retained
Capital Need and
Capital relative to Ratings Agencies, Regulators and peers
Actual Capital
Capital Assessment
Return capital to shareholders when actual capital exceeds
need, or raise capital when exceeds actual capital
Capital Plan
Allocation to business units based on an economic
capital determination
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Capital Allocation
(…and not just consequences)
4. CONCLUSION
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Conclusion
Manage risk but……
Risk is not volatility
Beware procyclical risk appetite
 Set too high in good times
 Reduced during bad times
Avoid just-in-time capital structures
Wealth dependent risk appetite is the primary determinant of
tipping points with leverage as an amplier
…. live with uncertainty
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