Uses and Misuses of Required Economic Capital Brian Dvorak Managing Director Moody’s KMV...

Uses and Misuses of Required Economic Capital

Brian DvorakManaging DirectorMoody’s [email protected]

MOODY’S KMV COMPANY. ALL RIGHTS RESERVED.2 COPYRIGHT © 2005

Introduction: Regulatory Capital vs. Economic Capital

Banks must regularly calculate regulatory capital requirements 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 language of risk at major banks

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?

1 What Is Required Economic Capital?


0.00%

0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

Year

Actu

al P

ort

folio

Loss

Tail Risk measures the likelihood of extreme losses

Expected Loss, Unexpected Loss, and Tail Risk

Expected Loss is the average loss

Portfolio 2

Portfolio 1

Unexpected Loss measures the variability around the Expected Loss

(one standard deviation)


Portfolio Loss Distribution

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0.20%

0.40%

0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

2.00%

Year

Act

ual P

ortf

olio

Los

s

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 to the Expected Loss

EL Loss

Probability


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 CAaa

Economic Capital

Probability

2 How Do Banks Use Measures of Required 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 with available capital to gauge whether the degree of leverage is appropriate for the amount of risk undertaken and the institution’s 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

Cre

dit

Wo

rse

Qu

alit

y

Bet

ter

Low Leverage High

Portfolio Risk

Economic Capital


Strategic Planning and Capital Budgeting

Required economic capital is used for strategic planning and 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 portfolio risk 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 of

management 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 limits supplement 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 pricing

at 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

3 How Do Banks Misuse Measures of Required 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 management’s goals

5. Inappropriate pricing methods based on required economic capital









Book vs. Market-Based Economic Capital Adequacy

Most banks compare economic capital requirements for their loan portfolios with book measures of capital available

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

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

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

Banks are increasingly marking at least some segments of their loan portfolios to market/model, although challenges remain for retail, commercial real estate and structured finance loans









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 poor portfolio decisions

The question is what is the best way to perform these aggregations


Aggregation Across Portfolios

Some adopt a “silo” approach, where required economic capital is calculated separately for different portfolios, often with inconsistent models, then combined

Cross-portfolio correlation may be very difficult to estimate because models may not be consistent and/or requisite data may not exist

Alternatively, other banks adopt a broad perspective on the portfolio, combining different portfolios together in one model

This “holistic” approach tends to produce more consistent measurement of aggregate required economic capital

Most clients consider the model risk of the holistic approach to be lower than the silo approach


Aggregation Across Risk Types

Aggregation across risk types may be more important in terms 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 these aggregated measures of required economic capital are used for making important decisions









Required Economic Capital Through the Cycle

Many banks consider required economic capital to be a through-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 all model

parameters and the model itself must be calibrated TTC to produce an accurate TTC measure of required economic capital


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









Economic Capital Allocation: Contribution to Risk or Tail Risk

Risk Contribution is an exposure’s marginal contribution to the portfolio’s Unexpected Loss (standard deviation of losses)

Tail Risk Contribution is an exposure’s marginal contribution to a defined region of the portfolio loss distribution

For allocating required economic capital, a growing number of banks have moved away from Risk Contribution toward Tail Risk Contribution, but often measured with a large tail


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 management’s goals

What are management’s goals? Managing earnings or loss volatility? Managing the risk of extreme losses? Managing the risk of some less-extreme loss amount?









Using Required Economic Capital for Pricing

Early efforts at risk-based pricing of loans attempted to set a hurdle rate of return based on the incremental costs of the loan plus a target profit margin

Incremental costs typically included: direct costs of origination costs of funding (borrowed funds plus incremental

capital) taxes overhead

Often called a “RAROC” model, many banks still use this approach to price new loans, but there are often problems in the way these models have been implemented


Common Problems with RAROC Models

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

may be used Allocations of fixed costs are common

2. Costs often are based on measures that do not reflect the 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 standard “capital multiplier” to a standalone calculation of loan risk

Costs may be allocated to accounting concepts of capital, such as regulatory capital

3. Profitability targets may not be consistent across the bank and may not reflect true economic value creation/destruction


Defining the Target Return

An alternative to setting the target return according to a RAROC model is to set it based on the return/risk ratio of 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 most efficient way to proceed, but at least it provides useful guidance that will enable the bank to create an optimal portfolio gradually: Every action should improve the return/risk ratio or it

should not be undertaken


Summary

Required economic capital has become the language of risk at many banks

It is used for many more applications than simply capital adequacy

Sometimes banks mis-measure or misuse measures of required economic capital

Many of these problems may be solved now, and others through more and better research

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Uses and Misuses of Required Economic Capital Brian Dvorak Managing Director Moody’s KMV...

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