Financial Enterprise Risk Management by Sweeting, Paul. Copyright 2011, Cambridge University Press. Reproduced With permission of Cambridge University Press, US~BOOKS in the format electronic usage via copyright Clearance Center. 18 Economic capital 18.1 Introduction ‘The calculation of economic capital brings together many of the principles discussed throughout this book, covering risk measures and aggregation in par- ticular detail. The issue of economic capital is also important to a number of departments within a financial organisation. One way to see the extent to which this is true is to consider why economic capital might be calculated. However, ft is important fist w uuderstand exactly what economic capital is. 18.2. Definition of economic capital ‘There are a number of ways that economic capital can be defined, but most kL;) >1—a, where k> 0, for all #> 0, ‘Ko increases as the volatility ofthe assets relative to the liabilities increases, and falls asthe expected return on the assets relative to the liabilities increases. ‘An increased level of correlation between the assets and liabilities also results in a reduction in Ko. If the assets and liabilities are projected stochastically, then the time inter- val used is important. Because solvency is measured only at discrete intervals, there is the possibilty that, whilst a firm is solvent at 1wo adjacent observa- tions, it might have been insolvent at some point between them, Whilst this can be explained by the volatility present in the models, there are also practical 18.7 Economic capital and risk optimisation 467 reasons why this might occur. In particular, if cash outflows occur before inflows over the course of a year, then 2 potentially solvent position at the end of the year is imelevant if insufficient assets were available to meet the ‘outflows atthe start ofthe year. ‘Another issue with this approach is that the range of parameters required ccan be enormous. In particular, the number of correlations required increases exponentially with the number of variables. Parameters such as correlation and ‘variance are also unstable over time, meaning that it can be dangerous to place too much reliance on the results of a model such as this one. 18.6.2 Practical approaches For the above approach to be implemented, measures of assets and liabilities ‘must be chosen and projected, and measures of risk must be chosen. ‘The most obvious approach is to consider the probability of ruin based on the market or market-equivalent value of the assets and liabilities. The proba- bility of ruin isthe probability thatthe value of assets will fall below the value of liabilities If a maximum acceptable probability of ruin is defined, then this calculation returns the additional value of assets that must be held to achieve this level of security. Along with all ofthe other assumptions, a decision must be taken on how these additional assets will be invested, since this will have an impact on the value of assets that must be held. ‘The concept of the probability of ruin can be extended to the cost of ruin for policyholders (in an insurance company) or account holders (in a bank). ‘This is the amount lost by policyholders in the event of a firm’s insolvency. AS this is a value rather than a ratio, it makes sense to standardise it somehow, ‘pethaps in relation to the total value of policyholder benefits. However, whilst this approach gives a more relevant measure of risk ~ for the policyholders, at least ~ the calculations required are more involved. 18.7 Economic capital and risk optimisation Economic capital can be used as a way of optimising the way in which a firm carries out its business. In particular, it can be used to ensure that the limited amount of capital that an institution has is put to the best use. (Optimisation means that the highest return is achieved for the level of risk that is taken. However, there are a number of ways in which this criterion can be defined in practice.468 Economic capital 18.7.1 Return on capital ‘Retums as a proportion of capital have already been discussed, and itis helpful to recognise that the measure of capital considered is economic capital. This ‘means that the return that a financial firm makes should be considered in the context of the capital it needs to hold — the excess of assets over liabilities — for the business it has written, However, since the return on capital could simply bbe atugmented by reducing the amount of capital held, it is more instructive to consider a measure where either the return or the economic capital is adjusted forsisk. The most common example of this is the risk-adjusted return on capital (ra). This isthe ratio of the risk-adjusted return to the economic capital held. ‘This means that if a firm reduces the amount of capital it holds and this results in the return being more risky, the return will be reduced correspondingly. ‘The return used can be an actual or an expected return, and the measure ‘can be celeulated for an entire firm or for an individual department. In fact, the nature ofthis measure means that it is well suited for comparing different lines of business within a firm as well as different firms. 18.7.2. Economic income created Retums on capital consider the standardised rate of return. In contrast, the economic income created (£/C) returns the amount of retum generated. It is calculated as: EIC=(r4—rwEC, as.) where ry is the hurdle rate of return and EC is the economic capital. This is rate of return that each unit of a product sold must earn to cover the additional amount of risk it generates. This is important, as the hurdle rate takes into account not just the riskiness of a product on a stand-alone basis, but also the extent to which it diversities other products sold. 18.7.3 Shareholder value ‘Both the retur on capital and the BC are single-period measures. This means that the term of any opportunity is ignored. One way of allowing for this is by considering the present value of a business. This is known as the shareholder value (SV), defined as: (18.2) Where rg is the rate of growth of the cash flows, This expression represents the discounted present value of all future cash flows. A related measure isthe 18.8 Capital allocation 469 shareholder value added (SV), which represents the present value of future ceash flows in excess of the economic capital invested in a product: svA (22-1) EC. as.) — 18.8 Capital allocation [As important as calculating the total capital requirement of a financial insti- tution is the need to allocate the capital that an institution has at its disposal between business lines. This has an impact on the amount of business that dif- {ferent departments can write, but also on the performance of each department ‘in terms of the return on that capital ‘The allocation of capital depends on the level of risk inherent in each depart- ‘ment, but also on the extent to Which each line of business acts as a diversifier to the rest of an organisation. 18.8.1 Allocating the benefits of diversification If new business line is launched, then the total capital requirement for a firm in unlikely to rise by as much as the stand-alone capital requirement for the new firm. Of course, a firm may choose not to allocate capital to individual busi- ‘ess lines at all, holding all capital centrally and allocating business arbitrarily ‘However, this means that products might be sold without a full understand- ing of their impact on the capital requirements for the business as a whole. If capital is allocated to business lines — as would usually be the case ~ then decision must therefore be taken on how to allow for the difference between the stand-alone requirement and the marginal addition. ‘A first thought might be for the company to retain the difference centrally. ‘This is a simple approach, and means that the capital allocated to each business line is not subject to a potentially arbitrary allocation formula, However, this is not a particularly efficient use of capital, and could make lines of business uncompetitive if other firms are able to set their prices with an allowance for the diversifying effect of that business. ‘Another easy approach would be to leave the capital requirements for all existing business lines unchanged, giving the full benefit of diversification to the new business line, on the grounds that it is only the existence of the new business line that created this benefit. However, this is to give the benefit470 Economic capital based on an accident of timing ~ had this new business line been in place ‘with an existing line being the new one, the diversification benefit would rest elsewhere. Such an approach is therefore arbitrary. 'A fairer approach is to perhaps start with the stand-alone capital require- ‘ments, but to allocate the diversification between the business lines somehow. ‘There are @ number of ways in which this could be done. For example, the reduction in capital could be divided in proportion to the undiversified reserves held. This is a simple approach, which is easy to justify, but might be perceived. as unfair ~a business line that provides more diversification might believe that it is due a higher proportion of the diversification beneft. ‘An approach that makes such an allowance is one that considers the ‘marginal contribution of each additional unit of business to the overall capi- tal required by the firm, This approach — known as the Euler capital allocation principal — gives the fairest allocation of capital between business lines, but it is also the most complicated approach, 18.8.2 Euler capital allocation principle ‘The Euler capital allocation principal can be used if a risk measure dis- plays positive homogeneity. Positive homogeneity is one of the axioms that must be satisfied for a risk measure to be coherent. In this context, it was defined in terms of a risk measure F(L) based on a loss function L that satisfied the expression F(kL) =kF(L), where k was @ constant. In fact, Euler's homogeneous function theorem is more general than this, and can De applied to any function exhibiting positive homogeneity of order q, so where F(kL) = F(L). Consider a firm with NV business lines, Let the loss in each line of business be Ly for the current volumes of business, such that: «as.4) Let ky be some multiple of each business line n, with each ky =k. If F(L) is ‘risk measure based on the loss function L that exhibits positive homogeneity of order q, then Euler's theorem states that: aF (kL) 8k, as.s) 18.9 Further reading 47 If q=1, then this reduces to: Fay Sn EOD, as) a Egusion 18.6 can be used to give the locaton of capital fra particular vist measure, ‘Standard deviation of losses For example, let F(L) =, the standard deviation of the loss, and let the 1osses be linked by a covariance matrix, Z. The total risk is therefore: F(L)=01 =('EK)'?, as) where k is a column vector of weights ky. Partially differentiating this expression with respect to ky gives: =@EH a C2) where o1,,1 is the covariance between the loss in line m and the total loss. Setting each k= 1, this means that the marginal contribution to the total risk of the risk inline mis 01, /o1. Ifthe economic capital required is proportional to the standard deviation of the losses, then this expression gives the multiple of the risk capital needed for line ‘Value at Risk and tail Value at Risk 1f the capital required is instead proportional to the VAR of the loss function, , at some level of confidence, a, VaRq(L), then it can be shown that the ‘marginal contribution of risk is given by E[Ln | L=VaR«(L)]. Similarly, if ‘the capital required is instead proportional tothe tail Value at Risk ofthe loss function, L, at some level of confidence, a, TVaRp(L), then it can be shown that the marginal contribution of riskis given by E(Ly |L > VaRa(L)] 18.9 Further reading [McNeil et al. (2005) gives further technical information on the calculation of risk capital, whilst Society of Actuaries [2004] provides a detailed practi- cal assessment of this topic. Whilst this document is mainly concerned with insurance companies, a banking perspective is available in Matten (2000),