Financial institutions failing to adopt economic capital approach, says PwC

Many financial institutions are failing to realise the full potential of using economic capital to enhance tactical and strategic planning, and optimise shareholder value, according to a new study by PricewaterhouseCoopers (PwC) in association with the Economist Intelligence Unit.

Economic capital and other advanced risk-based capital methodologies enable financial institutions to quantify risk exposures, the capital needed to cover them and the real risk-adjusted returns being made.

The study, entitled Effective capital management: Economic capital as an industry standard?, canvassed more than 200 financial services executives globally, and found 25% of companies had no intention of adopting economic capital at all and a third of non-adopters are sceptical about the value of economic capital itself. However, 44% of firms are already using it, with a further 13% planning to do so in the next year.

“Companies are generally not exploiting the full business value of economic capital, as it is sometimes seen primarily as an internal tool and not always communicated to institutional investors and other external stakeholders,” said Richard Barfield, a director at PwC in London.

Within the sector, the study found banks were far more active in disclosing economic capital than insurers or other financial services firms. About 70% of the world’s top 50 banks disclose usage of economic capital to their shareholders in their annual report, while 50% disclose economic capital results in their business units both in their annual reports and quarterly financial results.

There were also substantial regional differences in the study’s findings, with 37% of US financial institutions saying they had no plans to introduce economic capital, compared with 27% for Europe and 19% for the Asia-Pacific.

The main reason cited for adopting an economic capital approach also varied by region. In the US, 79% said the main reason was to define risk appetite, while 67% and 68% of Europe and Asia-Pacific institutions, respectively, said it was to improve strategic planning.

Conversely, regulators in Asia-Pacific were found to be the least likely to require the use of economic capital – 12% compared with 42% in the US. But the Asia-Pacific was also the region where the adoption of economic capital was most expected, with 55% of firms expecting to implement economic capital systems compared with 15% of companies in the US.