Basle Ii and Economic Capital

BASLE II AND ECONOMIC CAPITAL
BY
DR. EMMANUEL ABOLO

CHIEF ECONOMIST & GROUP HEAD, MARKET & OPERATIONAL RISK MANAGEMENT
ACCESS BANK PLC
16 December, 2008
The Quest for Excellence 1

Our philosophy
VISION MISSION
To transform our bank To go beyond the ordinary,

into a world-class financial to deliver the perceived impossible,
services provider. in the Quest for Excellence
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Outline
• Introduction/Conceptual Clarifications
• Development of Economic Capital
• Economic Capital & Basle II:
 Comparison of Economic Capital & Basle II (Regulatory capital)
• Recent Developments Encouraging the Use of Economic Capital
• Measurement of Economic Capital
• Basle II Accord – Objectives, Benefits & Banks’ Readiness
• Economic Capital Allocation for Commercial Bank Credit Risk
• Recap on Pillar 2
• Challenges & Way Forward

Introduction/Conceptual Clarifications
• Economic capital represents the emerging best practice for measuring

and reporting all kinds of risk across a financial organization;
• It is called "economic" capital because of the following factors:

 it measures risk in terms of economic realities rather than potentially
misleading regulatory or accounting rules;
 Part of the measurement process involves converting a risk distribution to

the amount of capital that is required to support the risk, in line with the
institutions target financial strength (eg. credit rating).
• Economic capital is the amount of risk capita, assessed on a realistic

basis, which a firm requires to cover the risks that it is running or
collecting as a going concern, such as market risk, credit risk, and
operational risk. It is the amount of money which is needed to secure
survival in a worst case scenario.

• Typically, it is calculated by determining the amount of capital that the

firm needs to ensure that its realistic balance sheet stays solvent over
a certain time period with a pre-specified probability. Therefore,
economic capital is often calculated as value at risk.

• Economic Capital
Economic capital is a measure of risk, not of capital held. As such, it is distinct
from familiar accounting and regulatory capital measures. The output of
economic capital models also differs from many other measures of capital
adequacy;
• Economic capital is based on a probabilistic assessment of potential
future losses and is therefore a potentially more forward-looking
measure of capital adequacy than traditional accounting measures;
• The development and implementation of a well-functioning economic

capital model can make bank management better equipped to
anticipate potential problems;

Conceptual Clarifications (Cont’d)
• Conceptually, economic capital can be expressed as protection against

unexpected future losses at a selected confidence level. This relationship is
presented graphically in the chart below:

Expected loss:
• Expected loss is the anticipated average loss over a defined period

of time. It represents a cost of doing business and are generally
expected to be absorbed by operating income. In the case of loan
losses, for example, the expected loss should be priced into the
yield and an appropriate charge included in the allowance for loan
and lease losses.
Unexpected loss:
• Unexpected loss is the potential for actual loss to exceed the
expected loss and is a measure of the uncertainty inherent in the
loss estimate. It is this possibility for unexpected losses to occur that
necessitates the holding of capital protection.

• Economic capital is typically defined as the difference between some given

percentile of a loss distribution and the expected loss. It is sometimes
referred to as "unexpected loss at the confidence level.“
Confidence Level
• The confidence level is established by bank management and can be
viewed as the risk of insolvency during a defined time period at which
management has chosen to operate. The higher the confidence level
selected, the lower the probability of insolvency.
• For instance, if management establishes a 99.97 percent

confidence level, that means they are accepting a 3 in 10,000
probability of the bank becoming insolvent during the next twelve
months. Many banks using economic capital models have selected
a confidence level between 99.96 and 99.98 percent, equivalent to
the insolvency rate expected for an AA or Aa credit rating.

Development of Economic Capital
The concept of Economic Capital was developed in the
banking sector.
• Basel I requires holding appropriate levels of capital for different
financial
risks:
 S&P AAA rating requires banks to hold capital at the 99.90% level
• Basel II expands the concept to operational risks:
 Quarterly reporting of operational risk exposure
• Insurance companies have picked up the EC concept only in the last

several years;
 Rating agencies are starting to give credit for internal models;
 Regulatory changes are accelerating pace of change;
 Larger companies are setting up proprietary stochastic models
• The European CRO Forum is in the process of recommending

standards for the acceptance of internal models for compliance with the
new Solvency II capital standards.

Economic Capital & Basle II
• The amount of capital a bank holds is an important factor supporting its

soundness and solvency;
• The Basel II framework is designed to improve the linkage of key
factors which contribute to bank solvency to a bank’s level of
capitalisation. Not only does capitalisation become more a function of
the risk profile of the organisation than under Basel I; and
• The Basel Committee aims at improving individual bank soundness

through reinforcing sound risk management practices.
These include:
 Sound governance and compliance disciplines;
 Improved (statistical) quantification of the various risks a bank
faces;
 Sophisticated tests of a bank’s ability to withstand and manage
changes to economic conditions;
 Greater market discipline on reporting and disclosure

Recent developments encouraging the use of EC
• Basle II Accord, a regulatory standard for international active banks;
• Solvency II/European Chief Risk Officer Forum
• General need to develop risk profiles and perform hedging analysis
• Measuring exposure to catastrophic events;
• Demands and increasing scrutiny by rating agencies/regulators

The European CRO Forum is establishing guidelines

for admissibility of internal EC models for Solvency I
• European Chief Risk Officer Forum is establishing guidelines for
calculation of EC and diversification of risk;
 “Principles for Regulatory Admissibility of Internal Models” (June 2005);
 Solvency Capital should be set to ensure a standardized likelihood of
economic loss to policyholders;
 Internal models should be based on adverse movement in Economic
Value of (Assets – Liabilities), calibrated to a target annual level of
99.5% probability of solvency;
 All material risks affecting the balance sheet should be modeled;
 Internal risk models should be fully implemented inside the company,
and reviewed (at least) annually;
 The CRO Forum advocates the admissibility of diversification benefits.
• In December 2005, the CRO Forum published a subsequent report

discussing suggested solutions to major issues in Solvency II
 EC is to be based on a market-consistent approach

• All major US rating agencies are developing or enhancing their

capital adequacy models. These include:
 Standard & Poor’s (S&P);
 Fitch;
 AM Best and Moody’s are also in the process of enhancing their
capital adequacy
models

Measurement of Economic Capital
• When calculating Economic Capital, three alternative approaches

are commonly used to measure risk: Risk of ruin, VAR and TVAR;
• TVAR captures the full extent of losses in the event of ruin;
• VAR quantifies the capital required to withstand losses at a

particular probability level;
• Risk of ruin is the probability of loss given the capital held;
• Required Economic Capital (REC) = “sufficient surplus capital

to cover potential losses, at a given risk tolerance level

Measurement of Economic Capital
When calculating EC, financial services companies use a range of

different confidence levels;
• Most banks use VAR

• Choice of confidence level and implied rating:
 Most European insurers are using one-year confidence levels ranging
from 99.5% to 99.99%;
 European regulators appear to be converging towards a one-year
99.5% confidence level for Solvency II;
 Confidence levels are typically linked to a target risk appetite and
financial strength rating;
 Where longer time horizons are used, a lower multi-year confidence
level can be justified (e.g., AA over five years vs. AA over one year);
 Moody’s and S&P have suggested using 99th percentile for AA financial
strength rating; and
 Fitch is using a 98.2 CTE level for AA rating.

Basle II Accord
Objectives
• Maintenance of overall capital levels globally;
• Promote competitive equality;
• Promote comprehensive risk management;
• Sensitive to risk;
• Focus on internationally active banks but applicable to all

Objectives.

Basle II Accord (Cont’d)
Benefits of Basle II
• Better risk assessment;

• Improves Industry risk management infrastructure;
• Actively encourage and support the shift to the new framework (eg
use of Basel II by rating agencies); and
• Consider impacts on the current business model:
 Look for opportunities to grow;
 Optimise capital structure;
 Exploit pricing opportunities; and
 Seek out takeover opportunities.

Basle II Accord (Cont’d)
Banks’ Readiness for Basle II
Generally, banks need to improve in the following areas to achieve

accreditation at the advanced levels within the new Accord:
• Time series data on defaults;

• Loss of information and meeting the cycle adjustment requirements
of Basel II;
• Enhancements to existing risk management systems;
• Increased rigour in rating tool development, testing and validation to
meet the more stringent requirements of Basel II; and
• Improvements to data warehouses, data interrogation and back
testing capabilities.
•

Economic Capital & Basel II
Capital provides sufficient assurance to prevent insolvency (i.e.

the financial state where liabilities exceed assets).
• Economic Capital is the amount of capital that shareholders require in
the absence of regulation. Factors to consider are:
 Leverage influencing target debt rating, and the cost of debt;
 Earnings volatility influencing analyst ratings, and the cost of
equity;
 Distress costs (liquidity risks, impact on strategy, increased
regulatory burden,
management time).
• Given the shortcomings of Basel I, economic capital has been the

primary focus with regulatory capital as the constraint. The
requirements of rating agencies also have to be considered. The
actual capital requirement for the Bank will therefore be the amount of
capital required to satisfy economic, regulatory and rating agencies.

Economic Capital & Basel II (Cont’d)
Basle II Pillar 2
• Principle 1: Banks should have a process for assessing their overall

capital adequacy in relation to their risk profile and a strategy for
maintaining their capital levels.
• Principle 2: Supervisors should review and evaluate banks’ internal

capital adequacy assessments and strategies, as well as their ability
to monitor and ensure their compliance with regulatory capital ratios.
Supervisors should take appropriate supervisory action if they are
not satisfied with the result of this process.

Regulatory and Economic Capital Comparison
Basel II Economic Capital Economic Capital

Regulatory minus Basle II
Regulatory Capital
Pillar 1 risk $5,000 $3,500 -$1,500
Credit Risk $500 $650 $150
Market Risk $1,250 $1,500 $250
Operational Risk $6,750 $5,650 -$1,100
Total Pillar 1 $0 $1,110 $1,100
Pillar 2 Risk $6,750 $6,750 $0

Differences Between (BASEL II) Regulatory Capital
& Economic Capital Measures
Conceptual Differences
• Relevant Business Entities;

• Confidence Levels;
• Time Horizons;
• Treatment of Expected Loss;
• Allowable Capital Instruments;
• Capital Deductions;
• Risk Type Coverage;
• Risk Type Definitions; and
• Cross-risk Diversification.

Differences Between (BASEL II) Regulatory
Capital & Economic Capital
Relevant Business Entities
• Regulatory Capital:
The individual licensed entity
• Economic Capital:
The entire business group perhaps including multiple licensed and
unregulated entities.

Differences Between (BASEL II) Regulatory Capital
& Economic Capital
Confidence Levels
• Regulatory Capital:
Probability that the bank will survive and thereby avoid
potential systemic disruption; and
• Probability that depositors (or their insurer) will not lose any
money even if the bank actually fails.
• The confidence level implicitly reflects society’s tolerance for

the risk of depositor loss and systemic disruption arising from
bank failure. However, It may not be explicitly specified.

Differences Between (BASEL II) Regulatory
Capital & Economic Capital
Confidence Levels
Economic Capital:
• Probability that the bank will survive.
• Conceptually, the chosen confidence level should represent

the point at which the marginal benefit, in terms of lower
funding costs and access to business for which higher credit
ratings (confidence levels) are a necessary condition, is
estimated to exactly offset the marginal cost of raising and
servicing additional equity.
• Unlike regulatory capital, the economic capital confidence level is not

influenced by potential systemic costs of bank failure, for which the
bank’s stockholders are not liable.

Differences Between (BASEL II) Regulatory Capital &
Economic Capital
Time Horizons:
• For a given amount of capital, the longer the time horizon the
lower the confidence level.
Regulatory Capital:
• Time needed for supervisors to identify and intervene if necessary to
address potentially life threatening problems;
• Time required to recapitalise after incurrence of serious losses;

• Normal supervisory review cycles.
Economic Capital
• Time needed to close out losing risk positions or businesses;
• Time needed to recapitalise after incurrence of serious losses;and
• Normal business planning and performance review and reporting
cycles.

Economic Capital
Treatment of Expected Loss
Regulatory Capital (Basel II):

• Provision or capital required for expected as well as unexpected
losses;
• Asymmetry of treatment of expected loss and expected income;

• At variance with IFRS (actual impairment only, not expected future
impairment).
Economic Capital:
• Unexpected losses only?
• No provision or capital required for expected loss?
• Symmetry of treatment of expected loss and expected income?

Economic Capital
Allowable Capital Instruments
Regulatory Capital
• Shareholders funds – “Fundamental” Tier 1;
• Hybrid debt/equity – “Innovative” Tier 1; and
• Subordinated debt – Tier 2.
Economic Capital
• Shareholders funds only

Economic Capital
Capital Deductions
Regulatory Capital:
• Implicitly assumes deducted items have 100% probability of zero value in
liquidation;
• Intangibles; and
• Investments in insurance, certain other financial business and non-financial
business subsidiaries.
Economic Capital:
• 100% probability of zero value unlikely for all deducted assets in
combination;
• No outright deductions;
• Model potential reductions in the value of these assets using the same time
horizons and confidence levels as for all other potential sources of
unexpected;
• loss, taking correlations into account.

Economic Capital
Risk Type Coverage and Definitions
(Basel II) Regulatory Economic
Pillar 1 Risks Credit (excluding concentration) Credit (including concentration)

(Trading) Market Risk (Trading) Market Risk
Operational Risk Operational Risk
Scaling Factor
Pillar 1 Total $xxxxxxx
Pillar 2 Risks Non-Traded Interest Rate Risk

Liquidity Risk
Strategic Risk
Other Risks
less Diversification Benefit
Pillar 1 + Pillar 2 Total $xxxxxxx $xxxxxxx

Economic Capital
Cross-Risk Diversification
Regulatory Capital (Basel II)

• No explicit recognition;
• Implies perfect correlation;
• Correlations unstable; and
• Cushion for other risks.
Economic Capital
• Recognises less than perfect correlations across risks;
• Need to reflect “stressed” rather than “normal” correlations; and
• Potentially significant reduction in overall risk.

Comparison of Economic & Basle II Regulatory Capital

Comparison of Economic & Basle II Regulatory Capital

Economic Capital Allocation for Commercial Credit Risk
Case Studies
• At its most fundamental level, credit risk is associated with loan

losses resulting from the occurrence of default and the subsequent
failure to collect in full the balances owed at the time of default.
• Expected credit losses associated with default can therefore be
determined from parameters associated with the likelihood of a loan
defaulting, or an estimate of the probability of default (PD) during a
defined time period, and the severity of loss expected to be
experienced in the event of a default, or an estimate of loss given
default (LGD).
• This ratio would be applied to a measure of estimated exposure at
default (EAD) to convert loss expectations to dollar amounts. The
resulting formula:
• Expected losses ($) = PD(%) * LGD(%) * EAD($).

Case Studies
• PD and LGD parameter estimates are drawn from the bank's

historical performance or from a mapping of internal portfolio risk
assessments to external information sources for PD and LGD
parameters.
• This requires that banks to have in place processes that enable
them to periodically assess credit risk exposures to individual
borrowers and counterparties with robust internal credit rating
systems that reflect implicit, if not explicit, assessments of loss
probability.
• Definitions of credit grades should be sufficiently detailed
and descriptive to clearly delineate risk level between
grades and should be applied consistently across all
business lines.

Case Studies
• For example, a bank could have a ten grade credit rating system
with associated one-year probabilities of default drawn from their
historical default experience within each grade as shown in Table I.
• In this example, the historical default rate experienced for loans

internally graded as a "6" has been one percent, which is
approximately equivalent to the long-term default frequency
associated with an S&P credit rating of BB.

Case Studies
Internal Loan 1 2 3 4 5 6 7 8 9 10
Grade
Average 0.03 0.06 0.10 0.25 0.50 1.00 2.50 8.00 22.00 100.0%
Probability of % % % % % % % % %
Default
Mapping to AA A BBB BBB BB+ BB B+ B CCC D

External +
Ratings
Estimates for loss severity in the event of default could likewise be constructed.
LGD grades assigned to loans are often associated with factors such as loan
type, collateral type, collateral values, guarantees, or credit protection such as
credit default swaps
Economic Capital for Operational Risk
As the figure shows, regulatory capital should cover (e.g. in the form
of provisions) both expected losses and unexpected losses (but
excluding extreme events) while economic capital should cover
unexpected losses.

Economic Capital for Operational Risk (Cont’d)
• In addition, economic capital should cover both risk capital with

99.9% scenarios and capital for extreme events. The latter is
important for modelling operational risk as “low frequency/high
severity” losses often occur. Examples of extreme events, we can
list 9/11 events in 2001, flooding in the Czech Republic in 2002 or
Hurricane Katrina in 2005.

Recap on Pillar 2
Pillar 2 is about assessing risks & implementing appropriate
mitigants.
Bank’s Focus Regulator’s Focus
• Identify and assess • Review and evaluate

material risks all risk and control
factors.
• Identify mitigating • Review and assess the bank’s
controls assessment.
• Identify amount of capital in to • Supervisory Conclusion
business plan, strategies and
profile.
• Produce capital number and -
assessment.
Challenges going forward
• In practice, managing the relationship between

Economic and Regulatory capital is complex, with no
simple answers;
• Correlation and diversification – critical number;
• Benchmarking against peers and market – paramount;
• Reporting and disclosure – onerous:
 Upside of educating market.
• Engagement, training and communication – crucial; and

• Complex groups with significant non banking business –
what is a common currency for capital

Thank you for listening

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BASLE II AND ECONOMIC CAPITAL

DR. EMMANUEL ABOLO

ACCESS BANK PLC

The Quest for Excellence 1

To transform our bank To go beyond the ordinary,

The Quest For Excellence

The Quest for Excellence 2

The Quest for Excellence 3

The Quest for Excellence 4

• Economic capital represents the emerging best practice for measuring

• It is called "economic" capital because of the following factors:

 Part of the measurement process involves converting a risk distribution to

• Economic capital is the amount of risk capita, assessed on a realistic

The Quest for Excellence 5

• Typically, it is calculated by determining the amount of capital that the

The Quest for Excellence 6

• The development and implementation of a well-functioning economic

The Quest for Excellence 7

• Conceptually, economic capital can be expressed as protection against

The Quest for Excellence 8

• Expected loss is the anticipated average loss over a defined period

The Quest for Excellence 9

• Economic capital is typically defined as the difference between some given

• For instance, if management establishes a 99.97 percent

The Quest for Excellence 10

• Insurance companies have picked up the EC concept only in the last

• The European CRO Forum is in the process of recommending

The Quest for Excellence 11

• The amount of capital a bank holds is an important factor supporting its

• The Basel Committee aims at improving individual bank soundness

The Quest for Excellence 12

• Basle II Accord, a regulatory standard for international active banks;

• Solvency II/European Chief Risk Officer Forum

• General need to develop risk profiles and perform hedging analysis

• Measuring exposure to catastrophic events;

• Demands and increasing scrutiny by rating agencies/regulators

The Quest for Excellence 13

The European CRO Forum is establishing guidelines

• In December 2005, the CRO Forum published a subsequent report

The Quest for Excellence 14

• All major US rating agencies are developing or enhancing their

The Quest for Excellence 15

• When calculating Economic Capital, three alternative approaches

• TVAR captures the full extent of losses in the event of ruin;

• VAR quantifies the capital required to withstand losses at a

• Required Economic Capital (REC) = “sufficient surplus capital

The Quest for Excellence 16

When calculating EC, financial services companies use a range of

• Most banks use VAR

The Quest for Excellence 17

• Promote competitive equality;

• Promote comprehensive risk management;

• Focus on internationally active banks but applicable to all

The Quest for Excellence 18

• Better risk assessment;

The Quest for Excellence 19

Generally, banks need to improve in the following areas to achieve

• Time series data on defaults;

The Quest for Excellence 20

Capital provides sufficient assurance to prevent insolvency (i.e.

• Given the shortcomings of Basel I, economic capital has been the

The Quest for Excellence 21

• Principle 1: Banks should have a process for assessing their overall