Allocating Portfolio Economic Capital to Sub-Portfolios
Introduction
Background on Economic Capital
Volatility and Capital: Measures of Risk
Conceptual Framework for Economic Capital Models and Required Inputs
Recovery Risk and Economic Capital
The Significance of Economic Capital to Financial Institutions
Economic Capital for Retail Credit Card Portfolios
Economic Capital for Counterparty Credit Risk
Economic Capital for Securitisations
Economic Capital for Market Risk
Measuring and Calculating Economic Operational Risk Capital
A Fundamental Look at Economic Capital and Risk-Based Profitability Measures
A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules
Allocating Portfolio Economic Capital to Sub-Portfolios
Spectral Capital Allocation
Evaluating Design Choices in Economic Capital Modelling: A Loss Function Approach
From an economic point of view, the risks that arise in a bank’s portfolio need to be covered by a corresponding amount of capital to absorb potential losses. This capital commonly is referred to as economic capital. It mainly represents the value of the company’s stock capital and comprises all reserves the bank is holding to cover occurring losses.11Depending on accounting standards, the economic capital may differ distinctively from the stock capital. For instance, in some European countries, hidden reserves play a crucial role in the definition of economic capital. See eg, Theiler (2004). In Matten (see 1996, p. 9), the role of capital is described as acting “as a buffer against future, unidentified, even relatively improbable losses, while still leaving the bank able to operate at the same level of capacity”.
In a situation of intensifying competition and decreasing return margins banks need to ensure an efficient use of their economic capital. It is becoming a core objective of risk management to ensure that the economic capital is invested efficiently in business lines yielding highest risk-adjusted performance. As a fundamental competitive necessity risk managers need to
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