The two forms of finance
Regulators differentiate between licensed banks and other, non-bank financial institutions such as (lesser licensed) asset management companies. Some may say that there is not much of a difference because ultimately, banks are simply managers of their own balance sheet.
Yet, the overlap is limited. Banks are not just gathering assets, they are also creating their own liabilities on an almost equivalent scale. The gap captured in the word „almost“ is representing their equity. With the taking of deposits and based on this the provision of loans, banks also engage in the creation of money.
Asset managers again come in two variants – those with freedom to choose their assets and those working with a given portfolio, at least at the start. In either case, the risks in the portfolio must be assessed. When buying an asset, its inherent risks must or should be assessed beforehand as part of an asset due-diligence process. When working with a given asset, these risks must still be assessed.
Triage of assets
To achieve this systematically, it is useful to learn from the military and emergency services. Apply a ‚S.T.A.R.T.‘ system to new assets taken on on a wholesale basis which is often the case if bad banks or not-so-bad insurance companies are offloading large asset portfolios to servicers/ portfolio managers. Simple Triage And Rapid Transportation is a first-response method of asset categorisation but it is not easy to apply; it takes a lot of experience and good systems which are managed well – these are two distinct challenges.
Transportation here means the application of the appropriate treatment of the risk symptoms – market risk – or value (at) risk for assets not marked or markable to market. See more under Risk Management below.
How to treat illiquid assets?
Regulatory Compliance differentiates between inherent and residual risks on either side of a control or risk-mitigation process in a financial institution. This also applies to illiquid assets albeit with more discretion absent a market price as a guide. Such guidance is only reliable in efficient markets anyway. An additional differentiator is between asset-inherent risks like credit risk and induced risks, for example general market risk, or political risk as sanctions risk. These risks need not move in synch. When looking at the correlation of illiquid assets with the market, we may think that some illiquid assets do not correlate with the market or correlate negatively e.g. on the bandwidth from -1 (perfect offset) via 0 (no correlation) to 1 (perfect correlation) and that they could hover somewhere around or even below zero.
Proxies are dangerous
For illiquid assets, valuation proxies are often sought. The easiest is to start with the purchase or transfer price and extrapolate from there along a reasonable trajectory. In some cases of legacy portfolios, a purchase price may not be available or evidently unsuitable as a basis. Using proxies based on assumed or allegedly observed correlation – positive or negative – is a risk in itself. For asset management, the risk looks privatised because a failure would only hit the ultimate beneficial owners (leaving the reputational damage for the asset manager aside). For banks, these assets would sit on the banking book and not on the trading book. The rules from the Bank for International Settlements (BIS) in Basel significantly restrict the migration of assets from the trading book to the banking book (or sometimes the other way) https://www.bis.org/basel_framework/chapter/RBC/25.htm?inforce=20220101&published=20191215. This may be because the banking book is functioning as a buffer – some may say a hiding place – for assets with unknown side effects. On a big enough scale or a wide enough spread, the banking book may no longer serve as a safe house and a revaluation may proliferate into something bigger due to the sensitivity and connectivity of the financial market. Some – and only some – of this interaction may be not only be inevitable but also desirable when it works as a heat exchanger to other market counterparties or market makers – however, it may turn into a wildfire.
Animal spirits
They are here and they never went away because animal sprits are just as much a force driving financial markets as prudence, systematic evaluation and regulation are. The difference is that animal sprits are, well, animated and can grow and spread much faster than reason or cool-headedness. The situation may be different now compared to the financial crisis of 2008 and banks in particular are better capitalised and better regulated, but these are quantitative differences only. The principal mechanics for a crisis are still intact, just their threshold is higher and some defences may provide some – but no absolute – containment. Whether a gravitational correction of the financial markets would count as Schumpeter’s creative destruction is a matter for discussion.
Where does wealth management fit in?
Third-party wealth management does not look insulated from the effect of shocks in the financial markets but isolated enough not to proliferate them.
Wealth management could have a buffer function, sitting tight in a market turmoil, buying opportunistically and acting as a breathing buffer when needed. The question is whether wealth managers have the mettle and the size to fulfil this possible function.
Wealth management may also engage in dark pool trading – not illegal but opaque where trades are executed without any public exposure until they are executed and cleared. The question is whether opacity should have an identifiable space to some extent. Do they counteract or feed animal spirits?
Risk Management – Basel II to Basel IV
Risk management starts with risk recognition and the logical next steps are risk assessment and quantification. Any operation is risky. Operations in financial markets are particularly risky because markets can move fast. The internal ratings-based approach (IRBA) of financial institutions introduced with Basel II was a natural response to the task but this was „internal“ and thereby, despite a number of common denominators across the industry, idiosyncratic. Idiosyncrasy may translate into „tailor-made“ for institutions but it makes the systematic review and evaluation process („SREP“), check here for details: https://www.bankingsupervision.europa.eu/activities/ srep/2024/html/ssm.srep202412_supervisorymethodology2024.en.html ) harder for regulators. As part of Basel IV, the Basel Committee emblazoned bank’s Pillar I IRBA approaches as inappropriate. There’s no use repeating the details but a summary can be found here: https:// kpmg.com/de/en/home/insights/overview/basel-iv/basel-iv-internal-ratings-based-approach- IRBA.html
This is logical, well-intentioned and probably necessary. Probability of default, loss given default, the all-important credit conversion factors (CCF) trying to make risks of different kinds comparably measurable were all laudable – as is the Basel IV effort to establish a unified taxonomy and more elaborate mandatory methodology. Yet, the question remains whether this represents the closest we can get to comprehensive risk control. The idea of central risk management has been around for a while.
Centrale di rischi – above and beyond?
„Centrale di rischi“ means „risk centre“ and is the name of the information system about financial institutions in Italy first established by the Banca d’Italia in 1962/64
Procedures provide stability but are not perfect. Intervention is sometimes necessary but then, like in aviation, the foremost risk are people. As such, the captain is naturally a bigger risk than the steward. The darker side of this thread can be found among the heretical thoughts but here I want to focus on structuring an organisation procedurally to reflect its risk environment. Our understanding of the correlation between the ‚procedural capture‘ of the business environment and operational success is still evolving.
No such thing as control
When it comes to risk control, „control“ is an exaggeration because the word implies command. Recognition of risks is key. For known unknowns in a well-structured organisation, the old espionage adage holds true: a recognised enemy is harmless.
Hence a good organisation needs big risk accounting. The Domesday Book, but dynamic it must be. Give derivatives a comprehensive framework. Externally, this has started with the introduction of a central counterparty but internally, particularly among non-FI (financial institution) asset managers, it is often still lacking.
Normally, an organisation or better a business must adjust to reality but at the outset, i.e. either at inception or during a rare watershed event, a business can adjust large parts of the reality relevant for itself to its set-up, ability and scope (within reason). It does so by choosing the products services to offer, their scale, scope and depth as well as other parameters such as price and the decisions to make or buy, all of which must be (or should be) reflected in the real way it is incorporated. Form follows function – business is not an art, at least not in this sense – albeit architects are needed in business, too.