Economic Capital – a common currency

for risk?

Jennifer Lang
 Agenda
• What is economic
capital?
• Why measure it?
• How do you calculate it?
• Measures of confidence
• What counts for
economic capital?
• Managing within an ERM
framework
 Purpose of economic capital
The purpose of economic capital is to assist
companies in appropriately measuring the
rate of return a company is getting in
proportion to the risk it is taking

A common currency of risk

 Economic capital is not
• Regulatory capital
• The value of the organisation
• A capital resource
 What is the point of EC?
• Solvency (but only in a light regulatory
environment)
• To make good risk reward trade-offs across
the organisation
– Pricing for risk
– Portfolio optimisation
– Investment assessment for new decisions
 An economic capital approach works if
• All financial decisions in an organisation
involve return on EC
• The management of the organisation
naturally talks about EC
• Measurement of financial performance
(personal or business) always includes an
economic capital measure
Perfect theoretical accuracy is MUCH less important than
full implementation throughout an organisation
 How do you calculate it?
Probability of loss (%)

Large Corporate Lending:

Probability of loss (%)

Lower average loss, longer tail
Personal Lending:
Higher average loss, shorter tail
Corporate
Risk coverage
Level
Retail
Economic
loss
reserve Capital

Zero Expected Potential Potential

losses level of “unexpected” "unexpected“
economic losses for which losses against Expected Expected
loss capital should be which it would be economic economic
held too expensive to loss loss
cover with capital
0% Loss rate 100%
0% Loss rate 100%

Different parts of the Financial services industry choose

different confidence levels on the distribution
 Differences across industries
– measure of confidence
• Banks – choose a single
point towards the extreme
• General insurers –
choose a multiple of a
single point, or TailVar,
closer to the centre
• Life insurers – depends
on heritage – mostly
choose a single point
 What does the tail look like?
• Look at a single risk type
(corporate loans from before)
• Could choose extreme point on
distribution (1 in 3,000 say)
• Could choose a multiple of 1 in 1 in 1 in 1 in
100 200 3,000
200
• Could choose TailVar at 1 in 100
TailVar
Tail at 11 in
Var at
100in 100

Most important factor is what will drive the right behaviour

across the organisation
 Differences between risk types
- model types
• Operational risk – often very skewed distributions based on little
data
• Credit risk – substantial data, but from fairly short time periods
• Mortality risk – substantial data, but again, short time periods,
without pandemics
• Property risk – catastrophe data based on combinations of financial
and non financial event information
• Casualty risk – very skewed distributions based on little data

Models become very much less reliable at the extremes of

the tail – no matter how much data you have
 Do the approaches make a difference?
• Different distributions could cause different
risk relativities
• General confidence in the model creates
better buy-in
• Extremities of any distribution are more
likely to be wrong
Choosing a multiple of a less extreme point on a distribution,
probably with a TailVar, is likely to give more confidence
 Balance Sheet issues
• Hidden reserves (eg conservatism in GI
liabilities compared with life)
• Assets with no value in stressed scenario
(goodwill, DAC?)
• Assets which are not marked to market

Starting point across entities should be as comparable as possible

 Diversification benefits
• Most institutions will have
diversification benefits
• Difficult problem is how to
allocate
• Best theoretical answer is
that the marginal cost of
capital to a business line
is the same as the
marginal cost to the
whole entity
 Return must match economic capital
• Measures of profit (before
cost of capital) should be
as consistent as possible
across entities:
– Long term contracts – profit
recognised up front?
– Credit spreads vs default
provisions?
– How should tax be treated?

Perfect theoretical accuracy less important than buy-in and

full implementation across organisation
 Economic Capital Control Cycle

Forecast Economic Execute and Measure

Capital and Return Actual Experience

Review Risk Appetite

Review Assumptions Confidence Levels
 Why Measure Economic Capital?
• Risk and return must
be measured together
• Process must be
robust
• Common currency of
risk and return
creates good decision
making
A draft of this paper (with suggestions for further
reading) is on the site http://ozrisk.net/ - please
continue the discussion in the comments there

Thanks to Tim Gorst, Andrew Reynolds and John

Evans who provided valuable feedback

All errors and omissions remain my own