Risk, Regulatory Capital and Capital Management Tim Shepheard-Walwyn Group Risk Director Barclays PLC
The Capital Conundrum Should regulatory capital and internal economic capital be the same? If so, what theory of capital underpins the Basel Committee approach? How does the Basel system address non portfolio business risks which are core to corporate finance theory? What has operational risk got to do with all this?
The EL Revolution The recognition of EL as a cost removes the single biggest portfolio based driver of volatility Capital is there to cover Unexpected Loss in the portfolio AND IN THE REST OF THE BUSINESS Earnings risk becomes the biggest determinant of internal capital allocation
A bit of history Basel Accord was a ‘fix’ to deal with the problem of the Japanese banks It was a rough solvency measure and never intended to be a basis for capital management But in a stable world, with interest margins stable and historic cost provisioning, a portfolio based volatility measure was a reasonable simplifying model
Why allocate economic capital? Normal WACC methods don’t work because deposits are available at risk free rate Portfolio optimisation is not possible without an internal pricing mechanism Is the rule shareholder based (i.e. improve Sharpe Ratio), or Is the rule debtholder (incl depositor) based (i.e. minimise risk)
How is economic capital linked to risk? Economic capital cannot be the same as total capital Economic capital does not need to be the same as total risk Shareholder risk (volatility) does need to be allocated Debtholder risk (stress) is a constraint on the business
Risks and time horizons Shareholder view (volatility) and debtholder view (stress) must reflect all risks Portfolio risks (credit & market) are only 30% of risk according to market prices Other risks (Operational and business risks) are becoming the dominant consideration for management But time horizons differ - portfolio risks matter more in short term, business risk in long term
Implications (1) Operational risk debate is a proxy for inadequacy of Basel model Must have greater focus on business risks (including operational losses) Must distinguish between equityholder (volatility) and debtholder (stress) view Must define purpose and time horizon for regulatory capital
Implications (2) Regulatory capital will never be fully aligned with ‘economic capital’ allocation Exercise is shareholder value maximisation subject to regulatory capital constraint Regulatory constraint is minimum level of acceptable default probability
A way forward? Recognise the different perspectives of regulators and firms Avoid excessive sophistication Base regulatory capital on stress measures not volatility measures Apply stress testing to business revenues as well as portfolios Don’t forget liquidity
Equity at risk - An alternative calculation for regulatory capital Capital = [E(Earnings) - Stress Revenues - Stress Portfolio - Stress Costs] x 3 Advantages: Simple, practicable, comparable
Conclusion Internal ratings approach is a big step in the right direction But full alignment between regulatory and economic capital is a chimera Recognise the problem and stop while we are ahead Don’t overengineer the process. If it can be simple, keep it simple