How to catch Risk?

Desperate attempts to catch Risk in new regulatory standards like Basel (II/III) for banks and Solvency (II) for insurers seem a dead end street....

What is happening?

That's the question we're about to answer in this blog!

Here are some observations:

• Risk Weighting
  All new risk valuating standards are based on Risk Weighting. Some assets (or liabilities) are assumed to be more risky than others. In practice, every asset class that has been identified as more or less 'safe', has turned out to be risky after all. E.G., government bonds  where - until the 2011 crisis  in Greece - assumed to be risk free. Unfortunately, nothing could be further from the truth...
  
  
  Nothing in life is risk free
• Tier Ratio's
  Instead of simple 'Equity to Asset Ratios', Tier 1 & 2 ratios where developed. These Tier ratios only take a fraction of the total assets into account. This leads to 'Equity to Risk-Weighted Assets Ratios' that insinuate adequate, substantial and reassuring 10-15% Capital ratios, while - in fact - they're not! These kind of ratios are misleading and create a false sense of safety....
  
  
  Tier Ratios lead people up the garden path
  
  
• Tail Hide and Seek
  As more and more risks are valued, regulated and urge for extra capital requirements, financial institutions will try to create extra return on risks that are formally not or only 'light weighted' measured. This way substantial risks are 'pushed' into the tail, fat risk tails are created and the sight on the real risks in the company becomes misty.
  
  
  Overregulation decreases the effect of good risk management

Illustration: Comparison 'Deutsche Bank' - 'Bank of America'
To illustrate what is happening, let's compare a giant like "Deutsche Bank" (DB) with the number one on the banking list, the "Bank of America" (BOA).

Financial Ratios	Deutsche Bank		Bank of America
(x 1 bn $)              Year:	2010	2009	2010	2009
Assets (A)	1906	1501	2265	2230
Liabilities (L)	1855	1463	2037	1999
Shareholder Equity (SE)	49	37	228	231
SE / A - Ratio	2.6%	2.4%	10.1%	10.4%
---------------------------------
Risk-Weighted Assets (RWA)	346	273	1456	1543
Assets (A)	1906	1501	2265	2230
RWA / A - Ratio	18%	18%	64%	69%
---------------------------------
Regulatory Capital (RC)	49	38	230	226
Risk-Weighted Assets (RWA)	346	273	1456	1543
Total Capital Ratio	14.1%	13.9%	15.8%	14.7%
---------------------------------
Tier 1 capital	43	34	164	160
Risk-Weighted Assets (RWA)	346	273	1456	1543
Tier 1 Capital Ratio	12.3%	12.6%	11.2%	10.4%

Although both banks have more or less the same 'Tier 1' and 'Total Capital Ratio', their individual risk profile is completely different. 

In the case of DB only 18% of the assets are assumed (marked) risky, while in the case of BOA around 64% is assumed risky and taken into account for a risk weighted solvency approach.

Notice that the simple gross 'Equity to Asset' Ratio (E/A-Ratio, or in short 'EAR')  of DB is only 2.6%, while the similar ratio of BOA is around 10.1%. If DB would be hit by an 5% impact loss, it would be in deep trouble.

Reflections

Our risk models have become too sophisticated and don't cover the area of 'Unkown Risk' enough. Unintentionally rand controversially, risk regulations and models make us implicitly sweep our real risks under the carpet. In principle Risks can be categorized as:

1. Known Risk Measured
2. Known Risk Unmeasured
3. Unknown Risk
4. Hidden Risk (knowingly or unknowingly)

It's time to admit that no asset or liability is completely free of risk and there's an overall substantial probability that risk - by definition - will hit eventually from an unexpected corner. To put things in perspective: In the 19th century, banks funded their assets with around 40-50% equity.

Conclusion
Including 'Unkown Risk', a simple gross E/A-Ratio (EAR) of a magnitude of 15-25% (across the total assets) would probably be the best kind of guarantee to accomplish a more sustainable financial system in the world. The new EAR could be best defined as the sum of an actuarial underpinned percentage on basis of the underlaying calculable covered risks and a TBD overall 10% 'add up' for unknown risks:

E/A-Ratio = EAR =  EAR_{[ calculable risk ]} + EAR_{[ unknown risk ]}

Until we've included Unkown Risk fully in our risk models, we'll stay in deep trouble.

Aftermath: 'Avatar Ratios'
To rate a company (bank), often it's not enough to look at just the traditional financial ratios. An interesting way to additionally rate a company in a more sophisticated way, is with the help of so - by me - called 'Avatar Ratios'.

Additional to financial ratios, 'Avatar Ratios' tell you more about what the intentions, (real) important issues and the 'drive' of a company and its employees are.

An 'Avatar Ratio Analysis' gives you more or less 'the embodiment' of all what drives a company. It can be constructed by making a word analysis of a crucial document or annual report of a company. In short: You simply download the annual report (or any other company characteristic document) and analyze it with a  'Word Frequency Counter' like WriteWords.

IAA Demo
As a demo, let's analyze the IAA's Strategic Plan

Frequency	Word
21	actuarial
10	strategic
10	develop
8	associations
6	standards
6	priorities
6	plans
6	objective
6	action
5	promote
5	profession
5	member
5	international
5	iaa
5	association
4	practice
4	maintain
4	key
4	global
4	encourage
4	education
3	worldwide
3	statement
3	relationships
3	plan
3	including
3	identify
3	establish
3	common
3	discussion
2	world
2	values
2	supranational
2	support
2	services
2	risk
2	relevant
2	provide
2	program
2	professionalism
2	professional
2	prioritize
2	principles
2	organizations
2	organization
2	mission
2	march
2	management
2	links
2	issues
2	internationale
2	help
2	fields
2	facilitate
2	countries
2	contact
2	conduct
2	areas
2	area
2	approved
2	among
2	actuaries
2	actuarielle
1	voluntary
1	vision
1	understanding
1	transparency
1	traditional
1	stakeholders
1	soundness
1	society
1	social
1	skills
1	sections
1	scope
1	scientific
1	role
1	review
1	research
1	reputation
1	relationship
1	regional
1	recommended
1	recognized
1	recognition
1	quality
1	public
1	protection
1	promotion
1	process
1	procedures
1	presidents
1	offered
1	objectivity
1	objectives
1	needs
1	model
1	members
1	knowledge
1	jurisdictions
1	involvement
1	integrity
1	improve
1	guidelines
1	forums
1	forum
1	financial
1	feasibility
1	experiences
1	expansion
1	examine
1	ensure
1	enhance
1	disciplinary
1	developing
1	developed
1	designation
1	decisions
1	decision
1	credential
1	create
1	cooperation
1	convergence
1	contributing
1	continuing
1	constructing
1	code
1	changing
1	availability
1	audiences
1	active
1	achieve
1	accountability
1	access

With the help of WriteWords we first create (on line) a frequency table. Next we cut out irrelevant words like 'and', 'the', etc. 

Here are the results:
(1) a  scrollable frequency table of all relevant words
(2) a 'Top 22 words' frequency table



In most cases - like this one - the result of simply putting the first 10 to 15 words in the top of the frequency table behind each other, is astonishing: It creates a kind of 'Identity Statement'. Here's the result for IAA's strategic plan, where even more than 20 words give a beautiful comprised identity statement:

IAA's Strategic Plan (Identity Statement comprised with WriteWords) Actuarial strategic develop associations. Standards, priorities plans objective action. Promote profession member international. IAA association practice maintain key. Global encourage education worldwide.

Avatar Analysis: Comparison 'Deutsche Bank' - 'Bank of America' 

Let's now go back to our banking case and compare 'Deutsche Bank' (DB) and the 'Bank of America' (BOA) with the help of a simple Avatar Ratio Analysis.

The Avatar Ratio Analys presents the word frequency (absolute numbers) and their relative frequency (= word frequency / total number of word in document). Here is the result:

Avatar Ratios	Deutsche Bank			Bank of America
	Freq.	Perc.		Freq.	Perc.
Governance	109	0.06%		25	0.02%
Risk	1458	0.79%		852	0.53%
Control	273	0.15%		156	0.10%
Total G+R+C	1840	1.00%		1033	0.64%
------------------
Client/Customer	359	0.20%		250	0.15%
Shareholder	169	0.09%		162	0.10%
------------------
Transparent	15	0.01%		2	0.00%
------------------
Employee	153	0.08%		63	0.04%
Director	40	0.02%		23	0.01%
------------------
Profit, Income	1001	0.54%		835	0.52%
------------------
Tot. nr. of words	161579	100%		184048	100%

Although I'll leave the final conclusions up to you, here are some remarkable observations:

• Total number of words
  
  
  Both companies (DB and BOA) need an enormous amount of words to explain their environment (clients, shareholders, rating agencies, etc) the essentials about what's going on in their company in a modest calendar year.
  
  To read an annual report of about 170,000 words, it would take an average reader (reading speed 200 to 250 words per minute) about 10-12 hours.
  
  Perhaps you, as an actuary, can read faster ( test it!: speed reading test ), but even at a speed of 500 wpm it would be an enormous task (5-6 hours) to fulfill.
  
  
• Governance, Risk & Control
  It's clear that DB puts much more energy (+60%) in communicating about themes as Governance Risk and Control than BOA. Also is clear that DB is far more transparent in its communication than BOA. This does (of course) not imply that BOA's risk and control frame is inferior to DB's. It could even be the opposite. It just shows that (and how) BOA handles and communicates differently (less open) from DB.
  
  
• Profit, Income, Shareholders + Clients and Employees
  DB and BOA weight Profit, Income and shareholders on more or less the same level. Both rank client/customer above shareholders. DB gives 'clients/customers' as well as employees double the attention of BOA!
  

At last
Next time you report to your board, include an Avatar Analysis of your report in your presentation!

Related Links, Sources:
- The biggest weakness of Basel III (2010)
- The Banker top 1000 list (2011) 
- Word Frequency Counter : WriteWords
- IAA's Strategic Plan  
- Bank of America: Annual Report 2010
- Deutsche Bank: Annual report 2010
- On line speed reading test 
- Spreadsheet containing this blog's DB and BOA analysis