Hull RMFI3 RD Ed CH 23
Hull RMFI3 RD Ed CH 23
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Economic Capital
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
1.2
0.8
Capital
0.6
0.4
0.2
-0.2
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Choice of Parameters
For a bank wishing to maintain a AArating, capital is chosen so that X is about 99.95% and time horizon is one year This is because statistics from rating agencies show that an AA-rated company should have a probability of only about 0.05% of defaulting in one year
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Loss
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Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
One Year Operational Risk Loss Distribution (Figure 23.5, page 496)
Loss
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Characteristics of Distributions
(Table 23.1, page 497)
Second Moment (Variance) Third Moment (Skewness) Fourth Moment (Kurtosis)
Zero
Low
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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No more than 10% of EGT could be invested in unlisted securities Peter Young the fund manager violated this rule The cost to Deutsche Bank was about $200 million
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Interactions of Risks
Credit Risk
LGD and PD depend on market value
Market Risk
Operational Risk
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Assume perfect correlation: overstates capital by about 40% Assume distributions are normal for the purposes of aggregation: understates capital by about 40% Hybrid approach: E E E seems to work reasonable well
n n total i 1 j 1 ij i j
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Business Unit 2 40
80 90
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Correlations
Market and credit risk within the same business unit: 0.5 Market and operational risk or credit and operational risk within the same business unit: 0.2 Market risks across business units: 0.4 Credit risk across business units: 0.6 Operational risk across business units: 0.0
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Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Business Unit 1: 100.0 Business Unit 2: 153.7 Whole bank: 203.2 Diversification benefit is 253.7 203.2 = 50.5 How should this be allocated to the business units? Equivalently how should the total economic capital of 203.2 be allocated?
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Alternatives
Allocate economic capital in proportion to the stand alone economic capitals Allocate economic capital in proportion to marginal contribution of business units to total economic capital Set economic capital for business unit i E equal to x where xi is the size of x business unit i
i i
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Deutsche Bank Economic Capital (millions of Euros) Table 23.4, page 503
Credit Risk Market Risk Operational Risk Diversification benefits Business Risk Total economic capital Total risk-weighted assets Core Tier 1 Capital (% of RWA) 12,785 13,160 3,682 (3,534) 1,085 27,178 346,204 8.7%
12.3%
14.1% 19
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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RAROC is the return on economic capital for a business unit The denominator is the economic capital allocated to the business unit The numerator is the expected profit. This can be before or after tax and can include a interest at the risk-free rate on the economic capital It is sometimes also referred to as RORAC
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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When lending in a certain region of the world an AA-rated bank estimates its average losses from defaults as 1% of outstanding loans per year The 99.9% worst case loss is 5% of outstanding loans Economic capital per $100 of loans is therefore $4
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Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Example continued
The banks spread between cost of funds and interest charged is 2.5% and administrative costs are 0.7%
0.025 100 0.01 100 0.007 100 RAROC 20% 4 .0 If interest on the economic capital is included and the risk free rate is 2% this becomes 0.88 22% 4 .0
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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Ex-ante vs Ex-post
RAROC was originally suggested as a tool to be used on an ex-ante basis. This means that we have to forecast the expected loss It is then used as a tool to allocate capital to the most profitable parts of the business It is also sometimes used on an ex-post basis for performance evaluation. Realized loss then replaces expected loss
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
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