Many financial institutions are failing to realize the full potential of risk-based capital management as a way to enhance their strategic and tactical planning and optimize shareholder wealth, according to a new study by PricewaterhouseCoopers.

The study revealed that 44% of companies already use economic capital with a further 13% planning to do so within the next 12 months.

However, a quarter of companies said that they have no intention of adopting economic capital at all and a third of non-adopters are skeptical about the value of economic capital itself.

The main business reasons cited by survey respondents for the uptake of economic capital are to improve their strategic planning, define their appetite for risk and set their risk limits. 95% of companies have or expect to achieve a better allocation of capital using economic capital than under a regulatory capital model.

Yet, in practice many institutions are not exploiting the full business value of economic capital, PwC said. The study found that levels of understanding among senior management about the business applications of economic capital vary greatly between institutions. Responsibility for managing economic capital still rests predominately with the risk management function rather than with the business units, it observed.

It also found that risk-adjusted performance measures are only infrequently being used to drive compensation for senior managers and business unit heads, and risk and financial reporting often remain separate. And, that the communication of the results of economic capital calculations within the organisation is often patchy.

“Economic capital is fast gaining ground within financial services companies globally. In the right hands economic capital is a powerful management tool which can provide a better understanding of the trade-off between risk and reward, leading to more incisive decision-making and more sustainable value creation. However, the evidence from our study suggests that too few senior managers are making the leap,” said Phil Rivett, partner, PwC.

The study also highlighted that more than one third of companies (36%) do not report economic capital results externally to shareholders and other key stakeholders. Banks are more active in disclosing economic capital than insurers or other financial services companies. Around 70% of the world’s top 50 banks disclose usage of economic capital to their shareholders via their annual report and 50% disclose economic capital results by business units both in their annual report and quarterly financial results.

“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. This could be why investors are regarded by respondents as being the least knowledgeable on the issue of economic
Capital,” commented Richard Barfield, director, PwC. “It will take time for economic capital to become a true industry standard so that shareholders and analysts can realistically compare one institution with another. Each step towards risk-based management of capital not only strengthens the ability of financial companies to make a reasonable return for their shareholders but also strengthens risk management.”

The study also found that U.S. firms have the least plans to introduce economic capital. Over the next year firms in the Asia-Pacific region are more likely than the other regions to introduce economic capital. Regulators in the Asia-Pacific area are least likely to require economic capital (12% compared to 42% in the U.S.), but it is also the region that says while economic capital may not be required it is expected.

The study was conducted by PwC in association with the Economist Intelligence Unit. It sought views from more than 200 senior financial services executives globally.