Risks Assessment Must Include Capital
WASHINGTON — Risk assessments that don’t include capital are incomplete, Fiserv’s Orlando Hanselman told his CU Enterprise Risk Management audience Oct. 2 at the aptly spelled Capital Hilton.
Hanselman, education programs director for Fiserv’s risk and compliance unit, added that these days, the only true measurement of capital adequacy is stress-tested capital that covers all risks and includes a probability spectrum, from likely to impossible. Only when an organization is including capital in its enterprise risk management process has the program reached maturity, he said.
And judging by what financial regulators are saying, including the NCUA, simply meeting statutory capital requirements won’t be enough to win over examiners, he said.
“Whether they call it BASEL III, the Dodd-Frank Act or whatever, [regulators] will ultimately say you have to customize your capital based on your risk profile,” Hanselman said.
That means credit unions should start thinking beyond a one-size fits all 7% well-capitalized standard, he urged. Instead, cooperative financial institutions should determine economic capital needs instead, which is based upon both quantifiable and subjective risk analysis.
Hanselman pitched an institution-wide number that breaks capital up into how much is allotted to cover credit, market, liquidity and operational risk, and he presented a slide with a pie chart to illustrate the practice. To arrive at macros numbers, risk officers must create a culture in which every single loan pricing decision includes a capital charge, as well as a funds transfer expense.
Although most credit unions think they use risk-based pricing when making lending decisions, they often don’t include those two key figures to truly determine the cost of risk. For example, Hanselman compared two $100,000 loans at 7.50% APR. One came with twice as much risk as the other, and after subtracting capital and fund transfer expense charges, the riskier loan produced an $80 net loss, compared to a $460 net profit for the less risky borrower.
While members–especially those with A-paper credit–will claim a competing institution will grant them the 7.5% rate, Hanselman encouraged credit unions to make risk-based underwriting decisions that would require raising the rate, negotiating less risky terms or simply denying the loan.
The economic capital assignment process involves all levels of a credit union, from the board and executive team to product management staff, who can give a better picture of product risks from a frontline perspective. Product risk worksheets completed by product managers work their way back up to senior executives, who make necessary adjustments before passing them up to the board room for product pricing and right sizing capital decisions, he said.