Economic capital ideas

Class Notes is an educational series, designed to pull together the threads of recent developments and thinking about key issues in risk management and derivatives dealing. In this instalment, Charles Smithson explains the concept behind economic capital

Economic capital is a measure of the amount of equity capital an enterprise needs to support a risk. More specifically, it is the amount of equity capital necessary to cover losses arising from that risk to some confidence level.1 For example, many of the large international banks define economic capital as the amount of equity capital needed to cover losses 99.97% of the time.

In contrast with an accounting view, where capital could be viewed on the right-hand side of the balance sheet, economic capital is a 'left-hand-side-of-the-balance-sheet' concept: the amount of capital needed is determined by the riskiness of the company's assets (including the firm's business units and activities).

While equity capital is the source of the 'needed' capital as defined by economic capital, the amount of equity capital required can be reduced by insurance and guarantees or by transferring risk to a third party.

Rationale

Firms face a range of risks: market risk, credit risk, insurance risk (for example, mortality and morbidity) and operational risk, as well as business risk, reputation risk, compliance risk and liquidity risk. Each risk has its own risk measures. For example, market risk measures include duration and convexity (for interest rates), the Greeks (delta, gamma, vega, theta, and so on) and, more recently, value-at-risk (VAR), while credit risk measures include characteristics of the obligor (probability of default), characteristics of the transaction (exposure in the event of default and loss in the event of default) and characteristics of the portfolio, which do not consider correlation (expected loss and concentrations).

For market, credit and operational risk at least, economic capital has become the language of risk. While the risk-type-specific risk measures are still used, market risk, credit risk and operational risk can all be expressed in terms of the amount of equity capital needed to support that risk and, since the measures are in currency units, we have an apples-to-apples measure.

In addition to providing a common language, economic capital permits the firm to express its risk appetite. (Above we noted that many large banks use a 99.97% confidence level for measuring economic capital. That confidence level was selected because it corresponds 100% minus the historical likelihood of an AA rated firm defaulting in a one-year period. This reflects the risk appetite of senior management and the board in terms of credit rating.)

1 Robert Merton and Andre Perold described risk capital as providing a kind of asset insurance against the possibility of lower-than-expected operating results.

2 The 2006 IFRI-CRO Forum survey into the economic capital practices of 17 banking institutions and 16 insurers in Europe, North America, Australia and Singapore indicated that insurance companies are more likely than banks to incorporate the different risk types into a single economic capital model.

3 The 2005 survey conducted by PricewaterhouseCoopers and The Economist Intelligence Unit found that 33% of the 200 financial institutions surveyed do not incorporate the correlation between risk types. The 2006 IFRI-CRO Forum survey suggested that a similar, albeit smaller, percentage of respondents were not incorporating correlation between risk types: six of the 33 participants reported that they use a simple summation approach. Of the 27 that attempted to incorporate inter-risk correlation, 23 characterised their approach to inter-risk diversification as top-down.

4 Consequently, the sum of stand-alone capital for the enterprise's individual business units or portfolios or transactions will be greater than the total economic capital for the enterprise.

5 At least in the case of economic capital for credit risk, the survey evidence indicates that firms are moving from standard-deviation-based to shortfall-based risk contributions. Between the 2002 and 2004 Rutter Associates' surveys of credit portfolio management practices, the use of standard-deviation-based risk contributions declined (from 50% to 38%), with the use of shortfall-based risk contributions increasing (from 13% to 33%).

REFERENCES

Christian C, 2006

Copula-based top-down approaches in financial risk aggregation

Working Paper 32, the University of Applied Sciences of bfi Vienna

IFRI Foundation and Chief Risk Officer Forum (CRO Forum), 2006

Insights from the joint IFRI/CRO forum survey on economic capital practice and applications

Merton R and A Perold, 1993

Theory of risk capital in financial firms

Journal of Applied Corporate Finance

Pearson N, 2002

Risk budgeting: portfolio problem solving using value at risk

Wiley

PricewaterhouseCoopers, 2005

Effective capital management: economic capital as an industry standard?

Rutter Associates, 2004

Rutter Associates survey of credit portfolio management practices

Sponsored by International Association of Credit Portfolio Managers, International Swaps and Derivatives Association and Risk Management Association

Rutter Associates

HSBC Financial Products Institute 2004-2005 survey of risk measurement & management practices of institutional investors

Stein R, 2007

Using economic capital as a tool

Best's Review.