Economic Capital – Denominator Of Strategic Risk Management

Introduction

Economic capital is going to be the key element in overall risk management strategy of the financial services industry especially banks and insurance companies. Volatilities in the international financial markets, higher frequencies of economic cycle, large scale globalisation, repeated corporate failures (by dishonest and inefficient business processes) etc. have aroused tremendous interest in sound risk management practices among regulators, governments, shareholders and other stakeholders. Comprehensive enterprise-wide risk management practices have become crucial for survival of these organisations. Basel II for banks is an honest regulatory attempt to prevent bank failures. The most prominent tool to prevent a bank or an insurance company failure is economic capital. Economic capital is the financial cushion provided by the business owners (shareholders) to prevent failure of the business due to large losses happening unexpectedly.

But economic capital has a high cost attached to it. The international average annual expected return on capital is around 20 per cent – a far higher price than that of any debt instrument. Overcapitalisation can be a value destroyer for the shareholders as it will reduce the return on capital but undercapitalisation can make business susceptible to failure, regulatory pressure and, in the event of large losses, can be fatal. The extent of economic capital a business should employ is a strategic decision. A good use of the economic capital will transform routine risk management to strategic risk management. In the evolving risk management practices, economic capital has become a denominator of strategic risk management. The majority of an organization’s critical management decisions will have to be guided by economic capital.

Economic capital is defined as the capital a bank should employ in order to remain solvent within one year with a certain degree of confidence. In other words, economic capital ensures solvency of the business at a given degree of confidence. The confidence level depends on the rating aspiration of the institution. A company aspiring to become highest rated will have to use a confidence level of around 99.99 per cent. The time period for all these calculations is usually one year.

Economic capital is different from the popularly known regulatory capital. Regulatory capital is decided by the regulator and is primarily meant to protect the depositor and ensure banking stability. However economic capital is based on the internal risk assessment of the organization and is aimed to create value for the shareholders. There was a wide gap between the regulatory capital and economic capital in Basel I. However this gap has been greatly reduced in the ongoing Basel II.

This article focuses on risks in a bank. A bank, normally, has three prominent risks – credit risk, market risk and operational risk. Basel II requires capital provision for all these risks. The next section discusses a methodology to calculate economic capital for credit risk – usually the biggest risk in a bank.

Methodology of Economic Capital Calculation

Economic capital can be calculated by several methods. Here is the brief mention of economic capital calculation for credit risk in a bank.

Credit portfolio in a bank can witness two kinds of losses. They are expected loss and unexpected loss. The expected loss is the cost of doing business and is normally recovered through pricing of the credit products. The product price must include a risk premium relevant in the product risk bucket. The long-term average of the portfolio losses is expected loss. Unexpected loss is a measure of variability of expected loss of the portfolio.

Figure A shows probability distribution of credit losses in a bank.

Figure A

Mean (?) of the credit loss distribution is expected loss. On an average the portfolio will suffer a loss equal to the expected loss in the long run. Standard deviation (?) of the distribution will denote unexpected loss for which economic capital will be required. The economic capital will be the multiple of unexpected loss and capital multiple (it depends on the confidence interval).

Figure B

The confidence interval will decide the probability of the organisation remaining solvent. Figure B shows a confidence interval of 99.5 per cent. It means that the bank will have unexpected losses less than or equal to the economic capital in 199 times out of 200.

The diagram in Figure C shows a process of economic capital calculation on portfolio and transaction levels. For credit assets, a bank needs to find probability of default (PD), loss given default (LGD), exposure at default (EAD) and default correlation (DC) among different customer accounts on an obligor basis. Thereafter expected loss and unexpected loss shall be calculated. Now the portfolio unexpected loss is calculated by the formula of portfolio standard deviation. This will give diversification benefit to the portfolio. Once portfolio unexpected losses are calculated, portfolio simulation will be required to draw the distribution and to judge the capital multiple. By multiplying the capital multiple with portfolio unexpected loss, portfolio economic capital will be found out. Now the portfolio economic capital will be allocated to each obligor depending on the absolute risk profile and risk contribution in the portfolio. There are many types of software available in the market to do all these calculations. But the person using those must be able to interpret the result.

Figure C

I, along with the credit risk management team in ING Vysya Bank, have carried out the exercise of estimating economic capital for credit risk. The exercise was like implementing the advanced internal rating method of Basel II for credit risk. Data availability in the required format happened to be the biggest issue in the whole exercise. Data of sufficiently longer period (at least three years) is necessary for a stable and realistic estimation of risk model parameters. In a few cases some intelligent and logical mapping of internal data with the available market data may be required.

Application of Economic Capital

An extensive range of application makes economic capital a strategic tool in the hands of bankers. Figure D outlines some of the important benefits an organization can derive by efficiently using economic capital. The entire risk adjusted return on capital (RAROC) framework works on the basis of economic capital.

Figure D

• Risk Based Pricing – Price of all credit products should carry risk premium according to the risk profile of the customer. Since a higher risk customer will need a higher economic capital, it must pay a higher capital charge.
• Customer Profitability Analysis – Customer profitability will be measured by RAROC (risk adjusted return on capital) i.e. accrued income net of expected loss divided by economic capital consumed.
• Risk Based Performance Measurement – Similarly performance of account relationship manager will be measured not by the quantum of assets booked but by the risk profile of those assets. This again will use RAROC framework.
• Complying Regulatory Requirement – Regulatory capital compliance asks for keeping capital to meet the unexpected loss. A bank adopting advanced internal rating method will have economic capital very near to the regulatory capital. In the still evolving capital requirement regime, economic capital and regulatory capital are going to be the same.
• Merger & Acquisition – Economic capital is going to be one of the important parameters affecting consolidation in the banking industry. A bank with higher capital availability (than the required) will have appetite to take over another bank. The opposite is true for banks with less capital (than the required).
• Customer Segmentation Analysis – Different types of customer segmentation analysis (geographic, product, risk etc.) may be done by the criterion of economic capital consumption. This will tremendously help in making customer segment specific strategy.
• Portfolio Optimisation – One of the most important uses of economic capital is portfolio optimization. In fact it encompasses the many benefits listed above. The contribution of different kinds of assets should be such that total economic capital for the portfolio is minimum. This can greatly help in reducing concentration risk.

Link to Strategy

The immense benefits of economic capital demand strategic treatment. Banks and other financial companies need to establish a robust economic capital management system. This system will try to optimize risk and return and hence add value to the organization. This allows organization to work effectively and efficiently and gain competitive advantage at the market place. Normally the strategy should be top down. It should be decided at the corporate level and should be in sync with the mission and vision of the organization.

It is difficult to follow differentiation strategy in financial services industry. Copying of products and services among the rival organizations is quite common. Organisations are competing on cost and almost all are trying to get cost advantage in the market place. An efficient economic capital system helps companies in adopting cost advantage. Companies are increasingly using economic capital to quantify the risks it is exposed to and calculate inherent return and cover. A company is required to make strategy of risk and return bands within which it is going to operate. The companies also need to involve all the stakeholders during the strategy formulation process including the regulator, business and division level staffs etc.

Future Trends

Financial services lending and investments are increasingly growing to incorporate economic capital in the decision-making process. The six Ps of marketing – product, price, place, promotion, process and people are going to be designed with economic capital in mind. There is a huge gap between regulatory capital and economic capital. Basel II has tried to reduce this gap to a great extent. Possibly in the next Basel release the regulatory and economic capital is going to be the same.

Use of economic capital is not widely prevalent in the majority of institutions in the emerging countries. Banks and other financial institutions of these countries will enhance the infrastructure and framework to establish a robust economic capital system in order to stay ahead in the fierce battles taking place in the market. An efficient and effective use of economic capital can surely be a source of competitive advantage.

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