The benefits
your bank can derive from Economic Capital and RAROC analysis
are extensive. Explore the links below to learn about some of
the most common applications:
UNDERSTAND WHERE SHAREHOLDERS CAPITAL IS INVESTED
As
Warren Buffett has stated, one of the most important jobs of a
CEO or CFO is capital allocation. Shareholders entrust management
to invest their capital wisely, knowing exactly where it is invested,
and what return they can expect on it. Management should also
make sure that any capital generated by a business unit is reinvested
wisely.
In
manufacturing organizations, capital investment is easy to understand
because it is largely required to finance plant and equipment.
However, it is more difficult to understand where capital is invested
in financial institutions, because capital is required to support
risk.
Therefore,
in order to understand where your shareholders capital is invested,
you must understand the risks in your financial institution. This
is the motivation behind Economic Capital linking risk to required
capital.
Manage capital levels based on an economic view of
capital adequacy
A
bank should undertake an assessment of capital adequacy at least
once a year. Capital adequacy is determined by making a comparison
between calculated Economic Capital and actual capital held by
the institution.
Whether
over or undercapitalized, firms can now take action as follows:
Measure Return on Equity (ROE) By Line of Business,
Product or Customer
One
of the most immediate benefits of measuring Economic Capital is
the ability to measure return on equity (ROE) at any level within
an organization business unit, products, customers, or even
transactions. This is an important input into the strategic planning
process identifying which activities to grow, shrink, or fix.
Although financial institutions have attempted to adopt an ROE
discipline through the use of such approaches as Economic Value
Added (EVA), they are missing one of the most important issues
understanding how much equity is required for each activity.
Economic Capital provides a sound theoretical basis for attributing
Economic Capital to all activities.
Meet regulatory risk-based capital adequacy modeling
requirements
Recent
and proposed regulatory guidance points to emerging regulatory
momentum for risk-based capital modeling. So far, these regulations
have been applied to subsets of the industry and momentum is growing.
These
regulations define risk-based capital adequacy modeling requirements
with substantially common concepts and language. Models should
include:
Comprehensive risk measurement: the model should address the
full range of risks faced by the institution, including all credit,
interest rate, market, and operational risks and should utilize
stress tests of key parameters that would affect the size of exposures
or degree of risk, e.g., for subprime lending: delinquency rates,
recovery rates, attrition rates, and utilization rates.
Objective and statistically sound linkage of risk to capital:
an example of this would be a statistically measured maximum
probability of becoming insolvent in conjunction with a target
public agency debt rating.
ERisk Abacus Economic Capital framework was
designed with precisely these features. Note, however, that while
Abacus uses an approach that appears to meet all of the recommendations
and requirements in these regulations, ERisk does not represent
that using Abacus will guarantee satisfaction of regulatory
requirements. ERisk maintains an open dialogue with regulators
on risk and Economic Capital measurement.
Price Loans to Earn Attractive, Risk-adjusted Profits
An
Economic Capital framework allows banking institutions to drive
a return on equity discipline into individual transaction decisions
through risk-based pricing. Particularly in markets where RAROC
frameworks are not yet prevalent, risk-based pricing can be a
key competitive differentiator. The few banks that are using risk-based
pricing are able to cherry pick the most profitable loans by
pricing aggressively; those not using this technique will accumulate
a disproportionate share of under-priced and higher-risk loans.
Assess the costs and benefits of risk transfer
When a bank engages in risk transfer, it is easy to evaluate
the cost it is the transaction cost plus any revenues foregone.
It is more difficult to measure the benefit of risk
reduction. Abacus provides a simple but powerful measure of risk reduction:
Economic Capital. By measuring the benefit of risk reduction in
terms of Economic Capital, the bank can calculate the ratio of
the cost of the transaction to the capital relief of the transaction
a measure of the RAROC ceded to the other counterparty. This
is illustrated below:
Ceded RAROC = [Return reduction + Transaction costs]/[Economic
Capital reduction]
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