Calculating Strategic Risk in Financial Institutions.

Abstract

Banks face many intangible hazards that are difficult to calculate. Strategic risk is one of the most critical factors affecting a bank's profitability, financial strength, and commercial success. The impact of risk on profit may be insignificant in the short term. Still, it may become highly significant in the medium and long term, with the potential to cause substantial financial losses and impair bank stability. Hence, strategic risk management is an important endeavor that must be carried out according to the rules set out under the Basel II framework. Analysis of strategic risk is a relatively new research enterprise. The current literature addresses the need to manage this risk and links it to the concept of economic capital, the amount of capital that a company should hold to survive such a risk. However, an action plan has yet to be produced. This paper attempts to address this gap by providing a mathematical analysis of the probability and effect of different strategic risk factors. Specifically, we develop a methodology for calculating a metric of strategic risk in terms of a bank's risk assets. Furthermore, we suggest a way of integrating this metric into the calculation of the capital adequacy ratio.