Financial Shocks, Risk Bearing Capacity and Social Responsibility

By Cenen Herrera
Writing from Martinez, San Francisco Bay Area

The recent financial shocks, i.e., financial institutions adversely affected by the sub-prime contagion and the large French bank rogue trader scandal of about $7 billion, demonstrated the importance of an institution’s risk bearing capacity and social responsibility. Risk bearing capacity represents the sum of net income retained by the institution over time plus freely usable paid-in capital contributed by its shareholders minus special reserves divided by the sum of its risk assets. Social responsibility is the ethical response of an institution to society in light of these financial shocks.

Strategic management provides the platform for projecting the level of risk bearing capacity that would be appropriate in meeting regulatory standards, e.g., Basel II requirements, and the planned cushion needed to protect an institution from expected and unexpected losses. On the one hand, expected losses such as bad debt expenses projected during an accounting period, e.g., after applying a probabilistic or non-probabilistic methodology, are viewed as part of operational expenses. On the other hand, unexpected losses are viewed as the risk of doing business. The adverse impact of the sub-prime contagion and the large French bank rouge trader scandal are examples of unexpected losses, i.e., risks of doing business. Both events (expected and unexpected losses) are traditionally considered in crafting the long-term plans of an institution. However, the magnitude and intensity of the recent financial shocks may have been extremely difficult to consider in the course of an ordinary strategic planning exercise. While sensitivity analysis and scenario planning tools provide the platforms for considering the degree of financial shocks that could be absorbed given a particular level of risk bearing capacity, adequate and effective controls are also needed to ensure that strategic plans are executed within the boundaries of the planning framework.

At the end of the day, what mattered most was the social responsibility demonstrated by the affected institutions in addressing the repercussions of the financial shocks, i.e., adverse impact of the sub-prime contagion and the French bank rogue trader scandal. Protecting the overall interest of the stakeholders goes beyond the metrics of risk bearing capacity. The affected institutions clearly demonstrated their social responsibility by prioritizing renewal efforts in bringing back normalcy to their operations.

At least two lessons emerged from the recent financial shocks: (i) the underpinnings of good governance such as character and reputation are invariably linked to performance, i.e., adverse impact of sub-prime contagion and the French rogue trader scandal are both governance and risk management issues, and (ii) the accompanying financial losses highlight the importance of an institution’s risk bearing capacity in meeting expected and unexpected losses, as well as the need to go beyond established controls in ensuring the effectiveness of risk management.