Use economic capital to determine risk

Economic capital (EC) refers to the amount of risk capital that a bank estimates to maintain solvency within a given confidence level and time frame. On the other hand, regulatory capital (RC) reflects the amount of capital required by banks under regulatory guidance and rules. In addition to comparing economic capital and regulatory capital, this article will also focus on how to measure EC and examine its relevance to banks.

Risk Management

Banks and financial institutions must take into account the long-term future uncertainty they face. It is in this context that the Basel Accord came into being, aimed at enhancing the risk management functions of important financial institutions. The agreement is a recommendation to the banking industry and consists of three sets of regulations: Basel I, Basel II and Basel III.

Basel II provides international instructions on the minimum amount of regulatory capital that banks should hold in response to their risks (such as credit risk, market risk, operational risk, counterparty risk, pension risk, etc.). Basel II also provides regulatory guidance and rules for regulatory capital modeling, and encourages companies to use economic capital models. EC, as a concept and risk measurement standard, is not a recent phenomenon, but it has quickly become an important measure between banks and financial institutions.

Key points

  • Banks and other financial institutions must take into account long-term uncertainty.
  • Economic capital is the amount of risk capital a bank needs within a given confidence level and time period.
  • EC is essential to support business decision-making, while regulatory capital attempts to set minimum capital requirements to deal with all risks.
  • Banks can use EC estimates to allocate capital across business units.
  • With the continuous development of the EC framework, economic capital may one day replace regulatory capital requirements.

Regulatory capital

When banks calculate their regulatory capital requirements and qualified capital, they must consider regulatory definitions, rules, and guidance. From a regulatory perspective, the minimum capital is part of the bank’s qualified capital. According to the supervisory guidance of Basel II, the total qualified capital is provided by Tier 3 capital:

Please note that depending on the laws and accounting systems of the member states of the Bank for International Settlements (BIS), these levels may be structured in various ways. In addition, different capital levels have different ability to absorb losses; Tier 1 capital has the strongest ability to absorb losses. Banks need to calculate the bank’s minimum capital requirements for credit risk, operational risk, market risk and other risks to determine how much Tier 1, Tier 2 and Tier 3 capital can support all risks.

Economic capital

Economic capital is a measure of risk expressed in capital. For example, a bank may want to know what level of capital is needed to maintain solvency within a certain confidence and time frame. In other words, from the bank’s point of view, EC can be regarded as the amount of risk capital; therefore, it is different from the measures required by RC. Economic capital is mainly used to support business decision-making, and RC aims to set minimum capital requirements for all risks of banks in accordance with a series of regulatory rules and guidance.

So far, because economic capital is a measure of bank-specific or internally available capital, there is no unified domestic or global definition. In addition, many banks have some things in common when defining economic capital. EC estimates can be included in Tier 1, Tier 2, Tier 3 elements or definitions used by rating agencies and other types of capital, such as planned income, unrealized profits, or implicit government guarantees.

Relevance of economic capital

EC is highly relevant because it can provide key answers to specific business decisions or to evaluate different business units of the bank. It also provides a tool for comparing RC.

Performance

Bank management can use EC estimates to allocate capital across business flows and promote units that provide ideal profits per unit of risk. Examples of performance measures involving EC include return on risk-adjusted capital (RORAC), return on risk-adjusted capital (RAROC), and economic value added (EVA). Figure 1 shows an example of RORAC calculation and how it can be compared between the business units of a bank or financial institution.

Business Return and/or profit European Community Estimates RORAC
Unit 1 50 million USD $100 million 50% (50 USD/100 USD)
Unit 2 30 million USD 120 million USD 25% (30 USD/120 USD)

Figure 1: RORAC of the two business units in one year

Figure 1 shows that compared to business unit 2, business unit 1 generates higher returns in EC terminology (or RORAC). Management will favor Business Unit 1, which consumes less EC but generates higher returns at the same time.

This kind of assessment is more practical in a bottom-up approach, which means that the EC assessment is carried out for each business unit and then aggregated into an overall EC number. In contrast, the top-down approach is more arbitrary, because EC is calibrated at the group level and then delivered to each business stream, where the criteria for capital allocation may be ambiguous.

Compared with RC

Another use of EC is to compare it with RC requirements. Figure 2 provides examples of some of the risks that can be assessed by the EC framework and how they can be compared with RC requirements.

Figure 2: RC requirements and EC estimates

Measure EC

Although the EC numbers of banks are partly driven by their risk tolerance, RC requirements are driven by the regulatory indicators specified in the regulatory guidelines and rulebooks. In addition, compared with the regulatory capital model under Basel II, such as the credit risk model based on Advanced Internal Ratings (AIRB), banks can choose how to model EC. For example, the bank can choose the functional form and parameter settings of its model. Therefore, EC modeling may adjust or ignore AIRB’s credit risk assumptions.

AIRB assumes that the loan portfolio is large and homogeneous, with greater long-term asset risk, as reflected in the so-called five-year maturity adjustment, and higher quality ratings have higher correlation to reflect systemic risks. It also assesses risk through rating categories and assumes that there is a perfect correlation between rating categories and the diversification within the rating categories.

The value at risk (VaR) model is a typical EC market, credit risk and other risk framework. However, for credit risk, it is usually called credit value at risk (CVaR). For example, consider the loss distribution of a loan portfolio of relatively safe loans. The expected loss represents the loss incurred in daily business, and the unexpected loss is the number of standard deviations from the expected loss (tail of the distribution).

In the current example, assume that the accidental loss is calibrated to a confidence level of 99.95%, which corresponds to an AA credit rating. Therefore, the bank may calibrate its economic capital model based on the management’s risk appetite, which is usually consistent with the bank’s target rating.

Some banks may use internally developed models to calculate their EC. However, banks can also use commercial software to help them perform EC calculations. Examples of such credit risk software include Moody’s KMV’s Portfolio Manager, Strategic Analytics, Credit Suisse’s Credit Risk+, and JPMorgan’s CreditMetrics.

Bottom line

EC is a measure of bank risk capital. This is not a new concept, but it has quickly become an important measure between banks and financial institutions. EC provides useful supplementary tools to RC for business-based decision-making. Banks are increasingly using EC frameworks and are likely to continue to grow in the future. A related question may be whether economic capital will one day replace regulatory capital requirements.

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