Uses and Misuses of Required Economic Capital

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Uses and Misuses of Required Economic Capital
Brian Dvorak Managing Director Moodys
KMV brian.dvorak_at_mkmv.com
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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

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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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• What Is Required Economic Capital?

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Expected Loss, Unexpected Loss, and Tail Risk
Portfolio 1
Portfolio 2
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Portfolio Loss Distribution
Probability
EL
Loss
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Portfolio Required Economic Capital
Probability

• 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

Aa
Aaa
A
Economic Capital
CA
CAa
CAaa
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• How Do Banks Use Measures of Required 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
  with available capital to gauge whether the
  degree of leverage is appropriate for the amount
  of risk undertaken 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
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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

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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

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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

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• How Do Banks Misuse Measures of Required 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 required
   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 required
   economic capital

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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

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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 required
   economic 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 poor portfolio decisions
• The question is what is the best way to perform
  these aggregations

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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

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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

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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 required
   economic capital

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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

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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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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 required
   economic capital

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Economic Capital Allocation Contribution to
Risk or Tail Risk
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
Risk Contribution is an exposures marginal
contribution to the portfolios Unexpected Loss
(standard deviation of losses)
Tail Risk Contribution is an exposures marginal
contribution to a defined region of the portfolio
loss distribution
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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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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 required
   economic capital

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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

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Common Problems with RAROC Models

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

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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

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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