Financial companies could be undervalued by non-disclosure of economic capital, says PwC

LONDON -- Financial firms that don’t disclose their economic capital calculations to shareholders and other stakeholders risk undervaluing their companies, according to a study issued in March by professional services firm PricewaterhouseCoopers (PwC) and the Economist Intelligence Unit.

The measurement of economic capital, whereby a firm calculates the capital it needs to cover the risks it faces and the real returns being made, is at the heart of the proposed Basle II capital adequacy accord.

The accord seeks to bring regulatory capital -- the protective capital that regulators require banks to set aside against the risks of the banking business -- into line with the economic capital that large banks allot based on their own measurement of the risks they face.

Economic capital systems

But the PwC report said that even though economic capital systems have become increasingly important to financial firms’ decision-making, they have not swept the board across the financial services industry. There is still a large body of companies, investors and analysts who stick firmly to more traditional growth and margin measurements to guide them in their decisions.

But companies are under increasing pressure from stakeholders and shareholders to generate better and more clearly understood results.

Economic capital is a tool that allows managers to compare performance across the activities of the group and make better-informed investment decisions, the report said.

Financial firms use economic capital systems for four main reasons:

• to ensure a safe level of capital to guard against disasters and meet regulatory requirements;

• to ensure risks are managed properly and to assess whether insurance policies or risk controls are cost-effective;

• to ensure the firm is not over-capitalised; and

• to ensure capital is being used efficiently to produce the best returns, and to assess strategy to support decision-making.

PWC outlined 10 rules for implementing economic capital, including discussing a proposed system with financial regulators, particularly once the Basle proposals are brought into effect by the Basle Committee on Banking Supervision, the body that in effect regulates international banking.

Another of the rules is to research what risk data is in the market-place. Ratings agencies, risk consultants and other institutions are covering certain risks -- especially op risks -- and are selling or pooling the information. So even if firms have only a few years’ data of their own, they can draw on the experience of others.

Companies should make sure the whole management team is behind the project, says PwC. They should be pragmatic -- data is critical to economic capital calculations, but judgement and experience are equally vital ingredients.

Firms must also keep up with the latest thinking on risk-assessment methods and should carry on educating managers once a system is in place. Moreover, senior executives must think carefully about how far down the company they want the system to spread.

And there must be continuity -- one of the commonest problems to arise is that only a few people understand the system -- and transparency for both internal and external stakeholders.

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