Uses and Misuses of Required Economic Capital11!15!05
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Transcript of 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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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.5 COPYRIGHT 2005
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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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.6 COPYRIGHT 2005
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
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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?
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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
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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
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Balancing Portfolio Risk, Economic Capital, Leverage and
Credit Quality
Credit
Wors
e
Qua
lity
Bette r
Low Leverage High
Portfolio
Risk
Economic
Capital
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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
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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
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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?
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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
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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
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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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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.19 COPYRIGHT 2005
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
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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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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.23 COPYRIGHT 2005
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
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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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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.26 COPYRIGHT 2005
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
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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
with managements goals
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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MOODYS KMV COMPANY. ALL RIGHTS RESERVED.29 COPYRIGHT 2005
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
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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