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

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

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

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 (-) -6.25% cash 6 equity 6 Option Cost (-) -0.25 Provision (-) -0.25% Net Spread 1.25% Fees (+) 0.50% Non-interest Expense (-) -0.50% Equity Credit (+) 0.30% Pre-Tax Net Income 1.55% Tax = 35% (-) -0.54% Net Income 1.01% Capital Charge (-) -0.75% New Idea!! (cap) × (cost of cap) Economic Value Added (EVA) 0.26% Assets Liab Eric G. Falkenstein 11/8/99

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

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

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

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

Reconciling Regulatory and Economic Capital “Well-capitalized” minimums : Tier 1 - 6.00% Tier 1 Leverage - 5.00% Total - 10.00% When you can’t reconcile to these (EPS woes), use “adequate” minimums Tier 1 - 4.00% Tier 1 Leverage - 4.00% Total - 8.00% 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

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

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

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

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

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

Basis Point Capital Attribution by Credit Grade: Survey Results Aa A Ba B Low 21 35 50 185 Avg. 78 132 196 444 High 120 240 364 700 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

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

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

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

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

Example of a bottom-up capital attribution

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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