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

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

4. What Is Required Economic Capital?

5. 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)

6. 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

7. 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

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

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

12. 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. 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. 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. How Do Banks Misuse Measures of Required Economic Capital?

16. 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

17. 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

18. 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. 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

20. 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. 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. 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. 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

24. 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. 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. 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

27. 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

28. 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. 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

30. 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. 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

32. 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. 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