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Economic Risk Capital at Key: The Big Picture. Eric G. Falkenstein 4/14/99 2 Without a true equity allocation, net income information is ambiguous “What.

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Presentation on theme: "Economic Risk Capital at Key: The Big Picture. Eric G. Falkenstein 4/14/99 2 Without a true equity allocation, net income information is ambiguous “What."— Presentation transcript:

1 Economic Risk Capital at Key: The Big Picture

2 Eric G. Falkenstein 4/14/99 2 Without a true equity allocation, net income 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 Why Economic Equity?

3 Eric G. Falkenstein 4/14/99 3 Leverage Realize Tax Benefits Maximize Returns in most likely scenario Avoid costs of future financial distress Keep ability to make acquisitions Highly Capitalized Thinly Capitalized Bank Capital - The Leverage Trade-Off Avoid regulatory constraints

4 Eric G. Falkenstein 4/14/99 4 KeyCorp’s Strategic Capital Objectives Maintain Capital levels consistent with achieving debt ratings objective, and satisfying regulatory minimums for well-capitalized banks Establish and maintain internal Capital allocations to the Lines of Business to support performance measurement incentive compensation strategic decision-making pricing risk management After considering strategic approaches to the regulatory capital needs, approach pricing and other business decisions based on economic risk, not regulatory capital

5 Eric G. Falkenstein 4/14/99 5 Summary of Bank Capital What is Bank Capital? Bank Capital is: Bank Capital is not: - Common Equity- Customer Deposits - Preferred Equity- Short-term Debt - Subordinated Debt- Other Liabilities - Loan Loss Reserve

6 Eric G. Falkenstein 4/14/99 6 Regulatory Capital Measures Fed, FDIC and OCC-mandated A) Tier I Capital Ratio – Tier I equity divided by risk-weighted assets – Risk-weighted assets have 100% weighting for loans, 20% weighting for OECD bank debt, 0% for Treasury debt Tier 1 Capital = Equity + TAPS - (Goodwill + Intangibles) Risk-weighted assets = On-balance-sheet assets * appropriate RW + converted off- balance-sheet * appropriate RW B) Total Capital Ratio – Tier I + Tier II equity divided by risk-weighted assets. Tier II capital consists mainly of qualifying subordinated debt and long-term preferred stock, plus Loan Loss Reserve (up to 1.25% of risk-weighted assets) C) Tier I Leverage Ratio – Uses quarterly average assets instead of risk-weighted assets

7 Eric G. Falkenstein 4/14/99 7 Regulatory Risk-Based Capital Measures Regulatory Use of Risk-Based Capital Ratios “Well-capitalized” minimums are: Tier 1 - 6.00% Tier 1 Leverage - 5.00% Total - 10.00% Key’s targets minimums are: Tier 1 - 7.75% Tangible Equity/Tangible Asset - 6.25%

8 Eric G. Falkenstein 4/14/99 8 Limitations of Regulatory Capital Risk-weightings do not recognize different loss rates for different loan types. AAA obligor with solid collateral has the same risk-weighting as a B obligor with no collateral Maintaining the minimum ratios does not fully satisfy regulators; they require comparability to peer bank capital levels

9 Eric G. Falkenstein 4/14/99 9 Rationale Behind Economic Risk Capital This section provides an executive overview of the recommended conceptual framework for allocating economic capital. Capital is required to enable a bank to absorb losses arising from unexpected events. The driver of capital requirements is, therefore, the potential for unexpected losses, not the potential fluctuation in positive earnings. Why does a bank need capital? NOYES To guard against fluctuations in positive earnings? To provide a buffer to absorb unexpected losses that would otherwise result in insolvency

10 Eric G. Falkenstein 4/14/99 10 Zero Losses Expected Level of Loss Potential “Unexpected” Losses for Which Capital Should be Held Potential “Unexpected” Losses Against Which It Would be too Expensive to Hold Capital Risk Coverage Level 0% Loss Rate 100 % ReserveCapital Earnings Cushion * Probability of Loss Potential Occurrence of Loss Idea Underlying the Economic Approach to Equity

11 Eric G. Falkenstein 4/14/99 11 Transaction Level Data Portfolio Summary Data Statistical Algorithm Risk Capital FacilityObligor e.g., Maturity Amort. Rate Collateral Type Covenants Fixed Floating e.g., Curr. Ratio Working Capital Total Debt Sales ($) Historical Data Correlation & Volatility Assumptions e.g., Grade 1 2 1yr x x 2yr x x Tenor Weakest Link Most Complex Link Credit Market Operational Other On and Off Balance Sheet Data ECONOMIC RISK CAPITAL PROCESS

12 Eric G. Falkenstein 4/14/99 12 Side Benefits Unifies risk measurement –risk capital is a number that allows apples-to-apples comparison of most risks Great way to approach consistency in incentive compensation, pricing, strategic evaluations –All should have an eye on ROE, and thus equity Great way to view strategic decisions impacted by regulatory requirements –If regulatory capital requirement is high and economic requirement is low, securitizations look more attractive

13 Eric G. Falkenstein 4/14/99 13 How Not to Allocate Capital Portfolio statistics Stand-alone comparables Any number that comes from a black box

14 Eric G. Falkenstein 4/14/99 14 How to Allocate Capital Commercial bucket by internal grade, map to Moody’s, allocate capital check to see the degree to which capital allocation is linked to profitability reporting, planning, pricing models, incentive compensation, and pro-forma income statements for potential acquisitions. Check to see what monthly or quarterly reports using capital allocation look like. Are risk buckets validated? [ifnot, they aren’t being used…]

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