uses and misuses of required economic capital11!15!05

8/6/2019 Uses and Misuses of Required Economic Capital11!15!05

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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.2 COPYRIGHT 2005

Introduction: Regulatory Capital vs. Economic Capital

Banks must regularly calculate regulatory capitalrequirements and ensure that adequate capital is

available to meet these requirements

Regulatory capital is an accounting concept; it does not

correspond with economic capital Major banks have transitioned away from using required

regulatory capital toward required economic capital as the

basis for making a wide variety of decisions

Required economic capital has emerged as the languageof riskat major banks


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Agenda

1. What Is Required Economic Capital?

2. How Do Banks Use Measures of

Required Economic Capital?

3. How Do Banks Misuse Measures of

Required Economic Capital?


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1 What Is Required Economic Capital?


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0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

Year

ActualPortfolioLos

Tail Risk measures thelikelihood of extreme losses

Expected Loss, Unexpected Loss, and Tail Risk

Expected

Loss is theaverage loss

Portfolio 2

Portfolio 1

Unexpected

Loss measuresthe variability

around theExpected Loss

(one standard

deviation)


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Portfolio Loss Distribution

0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

Year

ActualPortfolio

Loss

Rarely, the

portfolio has

very large

losses

Most of the time,

the portfolio has

smaller than the

Expected Loss

Sometimes, the portfolio

has losses equivalent tothe Expected Loss

EL Loss

Probability


7/33MOODYS KMV COMPANY. ALL RIGHTS RESERVED.7 COPYRIGHT 2005

Portfolio Required Economic Capital

The level of economic capital implies

a probability of capital exhaustion and

an associated debt rating Given the portfolio loss distribution

and a target debt rating, the required

economic capital may be inferred

AaaAaA

CA CAa CAaaEconomic Capital

Probability


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2 How Do Banks Use Measures ofRequired Economic Capital?



Banks Use Required Economic Capital for Many Purposes

Capital Adequacy Assessment

External Reporting

Strategic Planning

Capital Budgeting Risk and Performance Measurement

Limit Setting

Risk-Based Pricing Customer Profitability Analysis



Economic Capital Adequacy

Banks often compare economic capital requirements withavailable capitalto gauge whether the degree ofleverage

is appropriate for the amount ofriskundertaken and the

institutions desired credit quality

This comparison is often provided to: Regulators

Rating agencies

Investors

although these parties may not have a good

understanding of the measure



Balancing Portfolio Risk, Economic Capital, Leverage and

Credit Quality

Credit

Wors

e

Qua

lity

Bette r

Low Leverage High

Portfolio

Risk

Economic

Capital



Strategic Planning and Capital Budgeting

Required economic capital is used for strategic planningand capital budgeting:

Strategic scenario analysis

Capital allocation among business lines

Business line growth and performance targets

Acquisition/divestiture analysis



Measuring Risk and Business Line Performance

Required economic capital is used to measure portfoliorisk and the risk-adjusted performance of business lines

Business lines are usually charged for economic capital

use using a CAPM approach

This performance may be an important component ofmanagement incentive compensation

This creates challenges when the economic capital

model or parameters change



Credit Limits, Risk-Based Pricing and Customer Profitability

Dynamic, required economic capital based guidance limitssupplement hard notional counterparty limits

Such limits can help ensure that exposure reduction

occurs if credit quality deteriorates

Required economic capital is used for risk-based pricingat many banks: the price includes the cost of the

economic capital required

The cost of required economic capital is also used in

customer profitability calculations


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3 How Do Banks Misuse Measures ofRequired Economic Capital?



Five Ways Banks Sometimes Misuse Required Economic

Capital Measures

1. Comparison of required economic capital with available

book capital

2. Inaccurate aggregation across portfolios and risk types

3. Inappropriate measurement and use of through-the-cycle required economic capital

4. Allocation of required economic capital inconsistently

with managements goals

5. Inappropriate pricing methods based on requiredeconomic capital




Capital Measures


book capital








Book vs. Market-Based Economic Capital Adequacy

Most banks compare economic capital requirements fortheir loan portfolios with bookmeasures of capitalavailable

Required economic capital does not correspond with bookcapital, except perhaps at the margin

Ideally, banks should compare required economic capitalwith market-based measures of available capital

This would require, as a first step, calculating the marketvalue of the loan portfolio, including hedges

Banks are increasingly marking at least some segments oftheir loan portfolios to market/model, although challengesremain for retail, commercial real estate and structuredfinance loans


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Capital Measures


book capital







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Aggregation Across Portfolios and Risk Types

For more accurate risk and performance measurement,risk-based pricing and portfolio improvement decision-

making, many banks attempt to aggregate measures of

required economic capital across portfolios and risk types

Failure to do this aggregation accurately can lead to poorportfolio decisions

The question is what is the best way to perform these

aggregations


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Aggregation Across Risk Types

Aggregation across risk types may be more important interms of diversification than aggregation across portfolios,

but may be more difficult to measure well

Very few banks attempt to measure all risk types in one

consistent model In addition, many banks do not have good data for

estimating correlation across risk types

While required economic capital across risk types may not

be measured well, this only creates problems if theseaggregated measures of required economic capital are

used for making important decisions


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Capital Measures


book capital







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Required Economic Capital Through the Cycle

Many banks consider required economic capital to be athrough-the-cycle (TTC) measure

Some think it should be

Some think it is, because key model inputs, such as PDs,

are TTC measures This perspective may be mistaken, as allmodel

parameters and the model itself must be calibrated TTC to

produce an accurate TTC measure of required economic

capital


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Required Economic Capital Through the Cycle

Are TTC required economic capital measures desirable? Both risk and expected return vary considerably TTC

TTC risk measures bear little relationship to market prices

of risky assets

Many banks recognise that stabilised, TTC measures of

required economic capital create wrong signals for portfolio

management and pricing purposes


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Capital Measures


book capital







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Economic Capital Allocation: Contribution to Risk or Tail Risk

Risk Contribution is an

exposures marginal

contribution to theportfolios Unexpected Loss

(standard deviation of

losses)Tail Risk Contribution is an

exposures marginal

contribution to a defined regionof the portfolio loss distribution

For allocating required economic capital, a growing number of

banks have moved away from Risk Contribution toward TailRisk Contribution, but often measured with a large tail


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Aligning Economic Capital Allocation with Management Goals

For allocating marginal required economic capital of an

exposure, neither Risk Contribution nor Tail Risk

Contribution are wrong, unless they do not correspond


What are managements goals?

Managing earnings or loss volatility?

Managing the risk of extreme losses?

Managing the risk of some less-extreme loss amount?


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Capital Measures


book capital







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Using Required Economic Capital for Pricing

Early efforts at risk-based pricing of loans attempted toset a hurdle rate of return based on the incrementalcosts of the loan plus a target profit margin

Incremental costs typically included:

direct costs of origination

costs of funding (borrowed funds plus incrementalcapital)

taxes

overhead Often called a RAROC model, many banks still use this

approach to price new loans, but there are oftenproblems in the way these models have beenimplemented


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Common Problems with RAROC Models

1. Only marginal costs should be used for marginal pricingdecisions, yet RAROC model costs may not reflect truemarginal costs Average costs (e.g., cost of borrowed funds, variable overhead)

may be used

Allocations of fixed costs are common

1. Costs often are based on measures that do not reflectthe true economics, especially for capital and profitability Required economic capital may not be based on a calculation

that reflects the true portfolio risk, e.g., applying a standardcapital multiplier to a standalone calculation of loan risk

Costs may be allocated to accounting concepts of capital, suchas regulatory capital

1. Profitability targets may not be consistent across thebank and may not reflect true economic valuecreation/destruction


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Defining the Target Return

An alternative to setting the target return according to aRAROC model is to set it based on the return/risk ratioof a comparable benchmark portfolio

Unfortunately, there are no industry-standard benchmark

portfolios for loan portfolios Using the existing return/risk ratio of the loan portfolio to

define the target return is not necessarily the mostefficient way to proceed, but at least it provides usefulguidance that will enable the bank to create an optimalportfolio gradually:

Every action should improve the return/risk ratio or itshould not be undertaken


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Summary

Required economic capital has become the language ofrisk at many banks

It is used for many more applications than simply capital

adequacy

Sometimes banks mis-measure or misuse measures ofrequired economic capital

Many of these problems may be solved now, and others

through more and better research

uses and misuses of required economic capital11!15!05

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