Uses and Misuses of Required Economic Capital Brian Dvorak Managing Director Moody’s KMV brian.dvorak@mkmv.com

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

What Is Required Economic Capital? How Do Banks Use Measures of Required Economic Capital? How Do Banks Misuse Measures of Required Economic Capital?

What Is Required Economic Capital?

Expected Loss, Unexpected Loss, and Tail Risk Tail Risk measures the likelihood of extreme losses Portfolio 1 Expected Loss is the average loss Portfolio 2 Unexpected Loss measures the variability around the Expected Loss (one standard deviation)

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 Probability EL Loss

Portfolio Required Economic Capital Probability 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 A Aa Aaa Economic Capital CA CAa CAaa

How Do Banks Use Measures of Required Economic Capital?

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

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

Worse  Quality  Better Balancing Portfolio Risk, Economic Capital, Leverage and Credit Quality Worse  Quality  Better Credit Low  Leverage  High Portfolio Risk Economic Capital

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

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

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

How Do Banks Misuse Measures of Required Economic Capital?

Five Ways Banks Sometimes Misuse Required Economic Capital Measures Comparison of required economic capital with available book capital Inaccurate aggregation across portfolios and risk types Inappropriate measurement and use of through-the-cycle required economic capital Allocation of required economic capital inconsistently with management’s goals Inappropriate pricing methods based on required economic capital

Five Ways Banks Sometimes Misuse Required Economic Capital Measures Comparison of required economic capital with available book capital Inaccurate aggregation across portfolios and risk types Inappropriate measurement and use of through-the-cycle required economic capital Allocation of required economic capital inconsistently with management’s goals Inappropriate pricing methods based on required economic capital

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

Five Ways Banks Sometimes Misuse Required Economic Capital Measures Comparison of required economic capital with available book capital Inaccurate aggregation across portfolios and risk types Inappropriate measurement and use of through-the-cycle required economic capital Allocation of required economic capital inconsistently with management’s goals Inappropriate pricing methods based on required economic capital

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

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

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

Five Ways Banks Sometimes Misuse Required Economic Capital Measures Comparison of required economic capital with available book capital Inaccurate aggregation across portfolios and risk types Inappropriate measurement and use of through-the-cycle required economic capital Allocation of required economic capital inconsistently with management’s goals Inappropriate pricing methods based on required economic capital

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

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

Five Ways Banks Sometimes Misuse Required Economic Capital Measures Comparison of required economic capital with available book capital Inaccurate aggregation across portfolios and risk types Inappropriate measurement and use of through-the-cycle required economic capital Allocation of required economic capital inconsistently with management’s goals Inappropriate pricing methods based on required economic capital

Economic Capital Allocation: Contribution to Risk or Tail Risk 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 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

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?

Five Ways Banks Sometimes Misuse Required Economic Capital Measures Comparison of required economic capital with available book capital Inaccurate aggregation across portfolios and risk types Inappropriate measurement and use of through-the-cycle required economic capital Allocation of required economic capital inconsistently with management’s goals Inappropriate pricing methods based on required economic capital

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

Common Problems with RAROC Models 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 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 Profitability targets may not be consistent across the bank and may not reflect true economic value creation/destruction

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

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