ERisks economic capital experts offer the following guidelines to help you select an effective economic capital analysis solution:

• Ensure full coverage of all risk types
• Make certain that risks are measured on a consistent basis
• Verify theres a robust methodology for linking risk to capital
• Look out for common pitfalls

Ensure full coverage of all risk types

When stand-alone risks (that are not perfectly correlated) are combined, there is a diversification effect that reduces the total risk to less than the sum of the stand-alone risks. The diversification benefit associated with each risk is related to the size and correlation of each risk relative to all the other risks. Therefore, it is critical that your solution measure ALL risks in order to get any of them right.

For example, ERisk's Abacus solution covers all risks in the following taxonomy:

Make certain that risks are measured on a consistent basis

• Distribution of intrinsic value
• One-year time horizon
• Forward-looking, not historical volatility
• Full distribution, not just standard deviation.

Check out this article for more detailed information:

• Risk Capital Measurement in Financial Institutions by Oliver, Wyman & Company explains the foundation of the Economic Capital framework.

Verify theres a robust methodology for linking risk to capital

Economic Capital is the amount of capital required to ensure that a banks probability of default is in line with its desired financial strength. The cornerstone of any Economic Capital framework is the methodology for linking risk to required capital. ERisks approach, now the industry standard in the banking industry, provides a robust way to link risk to capital. There are two inputs to ERisks Economic Capital calculation: the one-year value distribution, and a solvency standard equal to the banks acceptable probability of default. Economic Capital is the difference between the mean of the distribution and the tail of the distribution corresponding to the solvency standard. This is illustrated in the picture below.

More detailed information can be found in these articles on Economic Capital and RAROC:

• Risk, Capital and Value Management in Financial Institutions Part I: The Debtholders Perspective by Oliver, Wyman & Company explains Economic Capital
  
  
• Risk, Capital and Value Measurement in Financial Institutions Part II: The Shareholders Perspective addresses RAROC and shareholder value.

Common pitfalls in implementing an Economic Capital System

• Methodology shortcomings
  • Using standard deviation rather than confidence interval
  • Measuring accounting earnings rather than value
  • Employing top-down historical volatility rather than bottom-up prospective volatility
  • Using stand-alone, rather than contributory volatility
• Implementation problems with home grown solutions
  • Underestimating the magnitude of the effort it takes years of effort from multi-disciplinary experts to design and implement a robust framework
  • Because projects take a long time and there are no intermediate results, there is significant risk that they may be cancelled prior to completion
• Implementation problems with vended solutions
  • Most vended solutions we have seen try to combine multiple risk-specific transaction-level systems. These require massive data warehouses and systems integration efforts they can take years to implement and frequently fail.
  • Custom consulting projects frequently create spreadsheet solutions that are left on the shelf due to insufficient/inadequate internal resources to carry forward
• Lack of results-orientation
  • Inertia due to lack of data / parameters something is better than nothing
  • Lack of buy-in lots of numbers but no resulting actions