1. Optimal Capital Allocation Strategy
Eric Falkenstein
Moody’s
downloadable at
ICBI Risk Management Conference
Geneva, 11/30/99

2. Big Picture Behind Enterprise-Wide Capital Allocation
Main Objectives:
Performance Measurement Within the Firm
pricing
incentive compensation
exit/entry strategies
securitizations
planning
Risk Management
Informs top-down capital strategy
Eric G. Falkenstein 11/8/99

3. Why Economic Equity?
Without a true equity allocation within the corporation, Net Income, ROA and ROE information is ambiguous
“What we generally call profits, the money left to service equity, is usually not profits at all. Until a business returns a profit that is greater than the cost of capital, it operates at a loss.”
Peter Drucker
Eric G. Falkenstein 11/8/99

4. Internal Profitability Measure: EVATM
Economic Profit (EP) =Economic Value Added( EVATM) =Net Income after Capital Charge( NIACC) =After Tax Profit - Capital Charge
Yield on Asset (+) 8.00% loan 100 debt 100
Funding Cost (-) % cash equity 6
Option Cost (-)
Provision (-) %
Net Spread 1.25%
Fees (+) %
Non-interest Expense (-) -0.50%
Equity Credit (+) 0.30%
Pre-Tax Net Income 1.55%
Tax = 35% (-) %
Net Income 1.01%
Capital Charge (-) % New Idea!! (cap) × (cost of cap) Economic Value Added (EVA) 0.26%
Assets
Liab
Eric G. Falkenstein 11/8/99

5. What About Status Quo Equity Levels?
Regulatory risk-weightings do not recognize different loss rates for different loan types. Aaa and B rated obligors should not both get 8% capital.
Maintaining the minimum ratios does not even fully satisfy regulators; they require comparability to peer bank capital levels for their ratings.
Eric G. Falkenstein 11/8/99

6. Risk Management Impact of Economic Capital Allocation
risk capital is a number that allows apples-to-apples comparison of most risks
encourages empirical validation
moves risk management from an audit function to a real part of the business, as output affects pricing models, incentive compensation, etc.
Eric G. Falkenstein 11/8/99

7. Top Down Target Considerations
Avoid regulatory constraints
Avoid costs of future
financial distress
Realize Tax Benefits
Keep ability to make
acquisitions
Maximize EPS in most
likely and current scenario
Highly
Capitalized
Thinly
Capitalized
Leverage
Eric G. Falkenstein 11/8/99

8. Top Down Rule of Thumb
Regulatory Minimums for “well-capitalized” banks (6.0%)
+ capital for potential acquisitions (0.5% Assets)
+ cushion for bad times (1.5% Assets)
=8.0% Tier 1 ratio
Or… look at peer equity levels for target debt rating, stay near median
…ignore if earnings are poor (EPS target is #1 priority)
Eric G. Falkenstein 11/8/99

9. Reconciling Regulatory and Economic Capital
“Well-capitalized” minimums : Tier % Tier 1 Leverage % Total %
When you can’t reconcile to these (EPS woes), use “adequate” minimums
Tier % Tier 1 Leverage % Total %
Ways of Reconciling
Use economic or regulatory regardless
Economic grossed up/down to top-down target which looks at regulatory and peer requirements
Eric G. Falkenstein 11/8/99

10. Optimal Capitalization Level (Final Capital Allocation)
Gross Up/Down Bottom-up Capital Allocations To The Top-down Optimal Capital Target
Example
$1.3B
$1.2B
Goodwill*
$200
Goodwill
$200
Other Intangible
Asset Risk
$110
Other Intangible
Asset Risk
$100
$220
Operational Risk
Operational Risk
$200
$220
Interest Rate/
Market Risk
Interest Rate/
Market Risk
$200
$550
Credit Risk
Credit Risk
$500
Bottom-Up Allocation
(First-Cut)
Optimal Capitalization Level
(Final Capital Allocation)
Eric G. Falkenstein 11/8/99

11. Basic Idea Underlying the Economic Approach to Equity
Earnings
Cushion,
sometimes mentioned
Probability of Loss
Risk Coverage Level
99.97%=Aa
Reserve
Capital
Potential “Unexpected”
Losses Against Which It
Would be too Expensive
to Hold Capital
Zero
Losses
Expected
Level of Loss
Potential “Unexpected”
Losses for Which
Capital Should be Held 0%
Loss Rate
100%
Eric G. Falkenstein 11/8/99

12. Basic Equation of Capital Allocation
This sort of language can give the impression capital is a messy but straightforward technical problem
Eric G. Falkenstein 11/8/99

13. In practice these only represent intuition for how to approach the problem
Graph is ambiguous about flows and stocks. If mark-to-market is used on commercial loans, what about consumer? If cash flow, what about future cash flows?
Cushion available for unexpected losses: book capital, cash flow and franchise value (i.e., rents from new business not currently on books, which is positively related to access to outside funding)
Marginal addition to firm-wide capital is the real target, very difficult to calculate and often very low (much LOB volatility is diversifiable within the firm)
At the 99.95% level, different reasonable assumptions can lead to very different capital levels--too much precision counterproductive
Eric G. Falkenstein 11/8/99

14. Literature is Ahead of Practice, as Usual
“The problem is to construct a system of information, accounting, economic indices and stimuli which permit local decision-making organs to valuate the advantage of their decisions from the point of view of the whole (firm)…[objective just like capital allocation!]
The hard thing in a model realization is to receive and often to construct necessary data which in many cases have considerable errors and sometimes are completely absent, since none needed them previously. [quite an understatement]”
Lenoid V. Kantorovich, U.S.S.R.
Economics Nobel acceptance speech, 1975
Academics often speak as if the problem is solved when in fact it has simply been identified
Eric G. Falkenstein 11/8/99

15. Basis Point Capital Attribution by Credit Grade: Survey Results
Aa A Ba B
Low
Avg
High
Demonstrates that capital still in Beta testing
source: First Manhattan Consulting Group, RMA “Winning the Credit Cycle Game: A road Map for Adding Shareholder Value Through Credit Portfolio Management”
Eric G. Falkenstein 11/8/99

16. How Not to Allocate Capital
Precise portfolio algorithms just a small part of the process (Credit Metrics, Credit Risk+, etc.)
Allocating different LOBs with identical expected losses different capital is a tough sell internally, though a common implication
In practice applied to mark-to-market or large corporate portfolios, which is a minority of most bank’s business
In practice one jury-rigs models to generate the capital implication previously thgought appropriate, and then present it as if this independently validates your capital assessment!
Monoline comparables (e.g. MBNA for credit card)
The LOB in question is always materially different. Stand-alones liquidity constrained and not diversified.
Any number that comes from a black box
You need statistical backup, anecdotes and a transparent explanation to withstand LOB counter arguments
Eric G. Falkenstein 11/8/99

17. How to Allocate Capital
1) Bucket exposures into homogeneous risk groupings
e.g., Product x Score x Collateral
2) Apply capital at the lowest level (e.g., to grade/tenor buckets within Media lending).
- use loss curves on consumer to forecast lifetime losses
- map commercial loans into agency ratings, use historical volatility of public bond defaults and internal experience to calculate expected losses
- capital is usually defined as a function of expected lifetime losses, by product type
- allocate other capital on case-by-case basis (intangibles, fixed assets, etc.)
3) Add up across LOBs, compare to top-down target
4) Gross up/down to top-down target
5) Redo by LOB if capital greatly at odds with current pricing
Eric G. Falkenstein 11/8/99

18. Risk Bucketing First Steps: Major Categories
Credit Risk
Commercial Lending
On-Balance-Sheet Loans and Lease
Unused Loan Commitments and Letters of Credit
Consumer Lending
Direct
Indirect
Residential Mortgage
Securitizations
Interest Rate and Market Risk
Interest Rate Risk (ALCO)
Market Risk (Trading)
Equity/Mezzanine Investments
Operating Risk
Deposits
Fiduciary Services
Non-Interest Expense
Other
Intangible Asset Risk
Investments in Subsidiaries
Fixed Assets
Goodwill
Eric G. Falkenstein 11/8/99

19. Commercial Loan Products Lines
Commercial loans
Commercial Real Estate
Mortgage
Construction
Corporate Commercial Loans
Large Corporate
Asset-Based Lending
Other Specialty (e.g., Media, Health Care)
Community Commercial Loans
Middle Market
Private Banking (MM lending secured by wealthy customer assets)
Consumer Bank Commercial Loans
Floor Plan (auto/marine/RV)
Small Business
Eric G. Falkenstein 11/8/99

20. Example of a bottom-up capital attribution

21. Typical Consumer Breakdown
Direct
Closed-End Loans
Auto
Marine RV
Mobile Home
Second Mortgage
Home Improvement
High-LTV Home Equity
Personal
Open-End Loans and Lines
Overdraft Protection
Unsecured Lines of Credit
Home Equity
Indirect
Auto
Auto Leases
Marine/RV
Education Loans
Credit Card
Subprime Home Equity
Subprime Auto
Manufactured Housing
Eric G. Falkenstein 11/8/99

22. Example of Consumer Risk Buckets
Eric G. Falkenstein 11/8/99

23. Different Buckets for Different Lines of Business
Eric G. Falkenstein 11/8/99

24. Next Step: Turn Loss information into Capital, usually through a function like the following
Eric G. Falkenstein 11/8/99

25. Present Data to LOB with Validation and Outline of Bottom-Up Algorithm for Maximum Effectiveness
Eric G. Falkenstein 11/8/99

26. Capital for Fixed Assets
Thought Experiment: traditional CRE limit is a Loan-to-value 70%--implies 30% equity on property.
This makes sense until one looks at this from a top-down perspective: if top-down target is 8%, fixed assets are going to get close to 8%.
Eric G. Falkenstein 11/8/99

27. Intangibles
For accountability purposes 100% seems optimal, while for cushion purposes something lower is probably appropriate.
Eric G. Falkenstein 11/8/99

28. Operational Risk Categories
Fiduciary Asset number comes from study done by First Manhattan for regulators, while noninterest expense number makes sure everyone’s covered.
While important, operation risk is almost impossible to measure by definition; solution: pay valuable lip service, allocate for noninterest expense, and ignore.
Eric G. Falkenstein 11/8/99

29. Deposits
Is this really necessary? Either way capital doesn’t affect the high average and marginal ROE for this segment.
Usually between 0.25% and 1.5%
Eric G. Falkenstein 11/8/99

30. Market Risk
Balance Sheet or ALCO risk much higher than trading risk, though not marked to market
ALCO risk usually 10 to 20% of book capital
Use VaR in conjunction with loss limits for trading books
Eric G. Falkenstein 11/8/99

31. Capital is not a Panacea
Capital doesn’t eliminate disagreements, it only makes them more explicit. People who expect capital to allow them to “optimize the balance sheet” from the top-down haven’t gotten their fingers dirty.
Capital is a cost of doing business, and is as important as other costs. Refining other non-interest expenses, expected losses and funds transfer pricing is still most useful.
Eric G. Falkenstein 11/8/99

32. Biggest Blind Spots
New businesses (artificially low current loss rates)
Tax arbitrage business (e.g., cross-border leases)
Business Cycle Uncertainties
cross-sectional patterns much more stable (N >>T)
small business, high LTV home equity, equity-collateral asset-lending aggressively increasing volume--recessionary performance unknown
Eric G. Falkenstein 11/8/99

33. Consultants are Key
How consultants add value: knowing the appropriate risk buckets, benchmarks for capital factors, how to construct the appropriate management information system, and general project management
Eric G. Falkenstein 11/8/99

34. Quick ways to test depth of capital impact within the firm
If no concrete answers to the following, assume they have not yet solved the problem, which in some cases implies capital is still only an academic exercise within the firm
How do you reconcile economic and regulatory requirements?
What portion of your capital allocation is allocated to credit?
Do you have historical loss rates and forecasts by internal grade and LOB?
How is capital integrated with
Planning?
Profitability reporting?
Pricing models?
Incentive compensation?
Eric G. Falkenstein 11/8/99

35. Conclusions
Capital is most relevant to internal profitability measurements, not top-down capital management
Validated, homogenous risk bucketing within the firm is the key
Most firms overstate the extent capital affect real decisions within the firm
Eric G. Falkenstein 11/8/99