By: John Robertson
Capital is the life-blood of financial institutions and has become more readily scrutinized since the global credit crisis. How one manages their capital is primarily driven by how well one manages their risk. The use of economic capital in measuring profitability enhances risk management efforts by providing a common indicator for risk. It provides pricing metrics such as RAROC (risk adjusted return on capital) and economic value added which include expected and unexpected losses consequently broadening the evaluation of the adequacy of capital in relation to the bank’s overall risk profile.
The first accounts of economic capital date back to the ancient Phoenicians, who took rudimentary tallies of frequency and severity of illnesses among rural farmers to gain an intuition of expected losses in productivity. These calculations were advanced by correlations with predictions of climate change, political outbreak, and birth rate change.
The primary value of economic capital is its application to decision-making and overall risk management. Economic capital is a measure of risk, not of capital held. It represents the amount of money which is needed to secure the survival in a worst case scenario; it is a buffer against expected shocks in market values. Economic capital measures risk using economic realities rather than accounting and regulatory rules, which can be misleading. The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the organization.
The allocation of economic capital to support credit risk begins with similar inputs to derive expected losses but considers other factors to determine unexpected losses, such as credit concentrations and default correlations among borrowers. Economic capital credit risk modeling measures the incremental risk that a transaction adds to a portfolio rather than the absolute level of risk associated with an individual transaction.
In a previous blog I restated a phrase I had heard long ago; “Margins will narrow forever”. How well you manage your capital will help you extend “forever”. Has your institution started using these types of risk measures? The Phoenicians did.
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