Presentation is loading. Please wait.

Presentation is loading. Please wait.

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

Similar presentations


Presentation on theme: "Uses and Misuses of Required Economic Capital Brian Dvorak Managing Director Moody’s KMV"— Presentation transcript:

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

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

3 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?

4 1 What Is Required Economic Capital?

5 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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)

6 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © Portfolio Loss Distribution 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

7 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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 Aaa Aa A CACA C Aa C Aaa Economic Capital Probability

8 2 How Do Banks Use Measures of Required Economic Capital?

9 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

10 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

11 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © Balancing Portfolio Risk, Economic Capital, Leverage and Credit Quality Credit Worse  Quality  Better Low  Leverage  High Portfolio Risk Economic Capital

12 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

13 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

14 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

15 3 How Do Banks Misuse Measures of Required Economic Capital?

16 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

17 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

18 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

19 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

20 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

21 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

22 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

23 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

24 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

25 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

26 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

27 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

28 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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?

29 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

30 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

31 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

32 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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

33 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. COPYRIGHT © 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


Download ppt "Uses and Misuses of Required Economic Capital Brian Dvorak Managing Director Moody’s KMV"

Similar presentations


Ads by Google