How changing a single risk measure could give banks the freedom the economy needs

In this guest essay, three of the City’s sharpest minds lay out a route for our biggest lenders to get their risk appetite back

Since the global financial crisis of 2007/8, banks have been less able to lend to the real economy. Much of their traditional financing activity has been displaced into the more lightly regulated “shadow banking” sector, particularly that of private equity funds, money market funds, credit funds and hedge funds. 

The reason for this shift of business is that banks have become less profitable and nimble. Many banks have a suppressed market equity value because of the lack of transparency over the risks which they run, and concerns over those risks, particularly on matters of liquidity. Investors are cautious over whether banks will always have enough cash to meet their outgoing liabilities as they arise. Regulators in turn apply higher standards to manage risk they often cannot see. 

Top-up charges and capital requirements are, however, blunt instruments, which might be (simultaneously) either too high or too low since they have been calibrated on the basis of an inadequate understanding of bank risk at a granular level. They are based on numbers which are considered (for the most part) in the aggregate. 

The issue for the banks is one of trust, which flows through to value. A mistrust of bank data is connected to shareholder concerns over banks’ volatile business flows and the risks arising from the fact that banks’ fundamental business model involves borrowing short-term and lending on a longer-term basis, i.e. so-called maturity transformation – an activity which is inherently unstable and makes banks susceptible to a “run”. With online banking, the impact of recent runs on banks has been more dramatic and rapid than ever before. To balance that risk, regulators apply ever more punishing regulatory requirements, forcing banks to raise capital – and at a higher rate than their ‘shadow’ bank equivalents. 

Technological advances, aligned with sophisticated legal reasoning, now make it feasible for banks to operate in a more cost-effective manner by undertaking a nuanced and granular analysis of their risk-adjusted cash flow or cash flow at risk (“CFaR”). Done properly, this will provide banks with a more accurate understanding of their risk position, which can be shared with investors and regulators. The result is that banks will themselves gain a better understanding of the risks they are truly taking. This should allow, over time, for an increase in their share value and a reduction in risk capital charges, since investors and regulators will become focused on the management of actual not perceived risk. 

Steps must be taken to address the current situation. Banks need to gather information on their cash inflow and outflow exposures. This will require an assessment of their CFaR, by analysing the risks and implications of each individual cash flow and then at that point aggregating the risk. This is in contrast to the current approach taken by many institutions which add and subtract aggregated risk metrics that may or may not be mathematically consistent and are likely to be insufficiently granular. The task involves the collection of data from core bank systems and the application of big data techniques. This data will need to be enriched by tagging each item with its original legal and other characteristics, allowing for a more accurate picture of the overall cash flow exposures. 

Some banks already do this, albeit in the limited case of existing product areas, legal entities or business lines, which means that they miss the understanding that comes from appreciating the risk arising from cash flows across the whole bank group, regardless of how they arise. 

For optimum results, matters could be taken one step further by introducing ways to track transactions across a financial group in real time through the use of blockchain or other technology. This would enable the creation of a “digital balance sheet” which can then be shared with the regulators, allowing for informed “live” discussion on specific elements of risk.

Banks should consider how the risks resulting from their cash flows can best be managed, from legal and other offsets to hedging strategies, freeing them up to play a bigger role in the financial markets. 

More granular data would allow banks to be nimbler in controlling their own risk and exposures, and to price client or counterparty trades in a more responsive way. 

Finally, banks need to be more transparent with shareholders and regulators. An approach based on better data combined with properly explained legal and regulatory points can demonstrate why existing perceptions should be reconsidered on the basis of the new data and analysis. For bank regulators, the new data should be significantly more useful than traditional sources of information, such as regular, but after-the-fact, reports.

Banks will soon face ever-increasing capital requirements and liquidity buffers, as is anticipated in a recent report of the Swiss National Bank over the collapse of Credit Suisse, unless they find new ways to manage their risk. 

There is now an opportunity for the banks to retake their essential place at the centre of the financial system, benefitting not just their shareholders, creditors and management, but the regulators themselves, as the custodians of the safety and soundness of the system as a whole. The benefits this will bring to banks and to wider society are self-evident. 

Barnabas Reynolds is a partner at Shearman & Sterling and the author of A New Direction of
Travel for Financial Regulation – A Time for Fresh Thinking, published by the Digital
Economy Initiative. Michael Adams is a consultant and former senior banker who led a team
which successfully implemented the cash flow at risk approach at a major financial
institution. Simon Dodds is Of Counsel at Shearman & Sterling and was formerly the co-
General Counsel and Head of Compliance at Deutsche Bank AG.