| Economic capital models gain momentum |
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| A number of larger European financial institutions have developed sophisticated economic capital models to calculate the amount of capital that they should hold. Attracted by the potential benefits, more institutions are likely to follow suit, writes Debra Mc Carthy of IBF. |
Throughout the lead-up to the implementation of the Capital Requirements Directive (CRD), there has been some confusion around what exactly is meant by the term “economic capital” and whether all banks are required to implement such models. A recent Irish Banking Federation (IBF) seminar aimed to clarify these issues as well as to highlight the key business benefits to implementing an economic capital model and the challenges faced by organisations in doing so.
Under Pillar 1 of the CRD, banks calculate their minimum regulatory capital requirement for credit risk, market risk and operational risk. While these three risks are considered the most easily quantifiable, they are not the only risks faced by banks. Banks are expected under Pillar 2 to determine the internal capital that they consider adequate to cover the nature and level of all risks faced.  | | James Dickson Leach, HSBC; Pieter Schermers, ING; Debra Mc Carthy, IBF; Sean Cooke, AIB; Monika Mars, PricewaterhouseCoopers (Netherlands); Craig Turrell, Accenture; Charles Stewart, Moody's KMV |
It is under the auspices of Pillar 2 that the term “economic capital” has gained momentum, with economic capital models generally considered to be the accepted tool used by institutions to determine how much capital is required given the institution’s risk profile and risk exposure. However, it is not a regulatory requirement to operate an economic capital model; institutions are permitted to use less sophisticated methods to determine how much capital they should hold for their Pillar 2 risks.
While a number of the larger European institutions have successfully developed economic capital models as part of their CRD implementation, for the remainder of institutions, focus is only now beginning to shift towards these models. In line with this shift, IBF organised a seminar, which took place on 9 April at the Westbury Hotel, Dublin, bringing together experts from Ireland, the UK and the Netherlands on topical aspects of economic capital.
What is an Economic Capital Model?
In its simplest terms an economic capital model allows a bank to compute a single risk measure for all risk types and calculate the amount of capital that the bank should hold in order to prevent insolvency from severe unexpected losses. Pieter Schermers of ING Bank - considered to be one of the forerunners of the economic capital concept - noted that one of their main motives for developing such models was to develop a single risk measure to cover both the banking and insurance activities of the bank.
One of the key themes discussed at the seminar was the importance of focusing on the business benefits of implementing the economic capital concept rather than the regulatory relief that may be attained. Monika Mars of PricewaterhouseCoopers (Netherlands) noted that, if implemented properly, economic capital can maximise the value of the business portfolio by optimising capital allocation, provide insights into the value of portfolios, facilitate banks in making more accurate risk-return decisions, strengthen the role of risk management and facilitate business managers in developing a better understanding of risk pockets.
With all these advantages, one could easily assume that attaining buy-in for economic capital would be an easy feat. However, the problem is the financial science or quantification that underpins these models. Any discussion around economic capital will invariably lead to mention of confidence levels. The confidence level chosen by a bank will largely depend on its target debt rating; the higher the confidence level, the higher the rating awarded. If a confidence level of 99.95%, for example, is selected by a bank, this will translate to holding sufficient capital to cover an event that might occur once in every 2,000 years. It can be very difficult to champion an initiative that would cover the bank in such seemingly unlikely circumstances. However, as we have all seen over the past eight months, these seemingly unlikely events can happen.
As noted, economic capital is about protecting the bank against unexpected losses. As such, stress testing forms an integral part of any robust model. However, the problem with stress testing is that it can be very subjective and it can be difficult to know where to stop as there is no worst possible scenario. As noted by James Dickson Leach of the HSBC Operational Risk Consulting Practice, if you go too far down the exceptional route, it makes it very difficult to get business buy-in; but if you don’t go far enough, the regulator may not accept your analysis. A useful tool suggested by Leach was to consider only those scenarios that the bank could survive, if adequately prepared.
More and more banks are likely to jump aboard the economic capital train over the coming years, as pressure from peers, rating agencies, regulators, and market participants mounts on banks to adequately understand their risk profile. As stressed by Sean Cooke of AIB, however, it must be remembered that judgement remains paramount to capital and risk assessment; banks cannot rely solely on quantitative models as it is not possible to reduce the entire risk profile of a bank into one number. |
Debra Mc Carthy is Adviser - Risk and Prudential Supervision, Irish Banking Federation
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