As published in Risk Management Magazine.

Copyright (c) 2001 ProQuest Information and Learning. All rights reserved. Copyright Risk Management Society Publishing, Inc. Aug 2001

Enterprising Solutions

For years, risk managers and regulators in the financial services industry have developed economic capital approaches to quantify risk. Over time, risk managers in other industries have developed different methods to apply economic capital in their risk management programs to address risk on an enterprise wide basis.

Holding Capital

Unlike book capital, which is an accounting measure that represents the sum of invested capital and retained earnings, economic capital represents the amount of capital required to absorb unexpected loss. If a company increases its risk exposures by lending to high-risk borrowers, its book capital reflects this shift over time only as the company experiences actual losses and retained profits. Its economic capital, however, will automatically increase the moment its risk exposures increase. A comparison between book capital and economic capital is useful for determining capital adequacy. A company is over-capitalized if its book capital is above economic capital, and is undercapitalized if the reverse is true.

Calculating Economic Capital

The basic steps for calculating economic capital are: 1) establish a solvency standard for the company, as reflected in its target debt rating; 2) measure the economic capital for individual risks based on the fundamental risk exposures and the solvency standard; and 3) aggregate the economic capital across individual risks, incorporating the correlation between risks.

This three-step process produces an economic capital quantification for each source of risk, such as risk type (credit, market, operational), business unit (investments, lending, insurance) or even product or customer. Economic capital enables management to analyze the components of, and trends in, its overall risk portfolio.

Applying Economic Capital

Economic capital can be used for a number of business applications, including performance measurement, product and relationship management, and risk transfer.

Once economic capital is calculated for each business unit, the profitability of the company's businesses can be measured on a risk-adjusted basis-risk-- adjusted return on capital (RAROC)-which is computed by dividing net income by economic capital.

Other measures of profitability, such as earnings, return on assets or return on equity, are not always comparable because different businesses take various levels of risk to generate their profits. By adjusting for the underlying risks, RAROC provides a profitability measure that is comparable across different businesses. As such, RAROC establishes the linkage between risk, capital and shareholder value. For example, a business that produces a RAROC above its cost of economic capital is adding to shareholder value, and vice versa.

Economic capital and RAROC analyses can be drilled down to the individual product and customer level to determine risk-adjusted profitability and pricing. Pricing models can be developed to support: product managers in structuring and pricing new products and making trade-off decisions between pricing and market share for existing products; relationship managers in establishing relationship plans and cross-selling strategies to achieve profitability targets for each relationship; and business managers in optimizing the mix of products and relationships in their business portfolios.

Finally, economic capital and RAROC provide an excellent framework for risk transfer decisions. In executing any risk transfer strategy, the economic benefits include lower expected losses and reduced loss volatility, while the economic costs include the insurance premium or hedging costs, as well as higher counterparty credit and operational risk exposures. The company is both ceding risk and ceding return, resulting in a "ceded RAROC."

If the ceded RAROC of a risk transfer strategy is lower than the company's cost of economic capital, then the strategy increases shareholder value because the cost of risk transfer is lower than the cost of risk retention. By comparing the ceded RAROCs of various risk transfer strategies, a company can compare different structures, prices and counterparties on an apples-to-apples basis.

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