Hull RMFI3 RD Ed CH 23

Economic Capital and RAROC
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C. Hull 2012
Economic Capital
A banks own assessment of the capital it requires
Model Used for Economic and Capital (Same as Regulatory Capital)

Figure 23.1, page 492
Expected Loss X% Worst Case Loss
1.2
0.8
Capital
0.6
0.4
0.2
Loss over time horizon

0 5 10 15 20 25 30 35 40
-0.2
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
The Basel II Regulatory Environment (Figure 23.2, page 493)

Total Risk
Non-Business Risk (regulatory capital):
Business Risk (no regulatory capital):
Credit Risk Market Risk Operational Risk
Risk from Strategic Decisions Reputation Risk
One-year Market Risk Gains/Loss Distribution (Figure 23.3, page 496)

0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 -6 Gain-4 -2 0 2 4 Loss 6
One-year Credit Risk Loss Distribution (Figure 23.4, page 496)

0.6 0.5 0.4 0.3 0.2 0.1 0 0 5 10 15
Loss
20
One Year Operational Risk Loss Distribution (Figure 23.5, page 496)
Loss
Characteristics of Distributions
(Table 23.1, page 497)
Second Moment (Variance) Third Moment (Skewness) Fourth Moment (Kurtosis)
Market Risk High

Credit Risk Operational Risk
Zero
Low
Moderate Moderate Moderate Low High High
Importance of Risks (page 497)

Type of Business
Commercial Banking Investment Banking & Trading
Most Important Risk Credit Risk

Market Risk and Credit Risk
Asset Management Operational Risk
10
European Growth Trust (Example of

Operational Risk in Asset Management) See Business Snapshot 23.1
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
11
Interactions of Risks
Credit Risk
LGD and PD depend on market value
Market Risk
Operational risks can be contingent on market moves or credit events
Operational Risk
12
Integrated Risk Management

Typically a bank calculates economic capital for different types of risk and different units It is then faced with the problem of aggregating the risks
13
Combining the Distributions
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
14
Example: Economic Capital Estimates (Table 23.2, page 500)

Business Unit 1 30
70 30
Market Risk Credit Risk Operational Risk
Business Unit 2 40
80 90
15
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
16
Total Economic Capital

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?
17
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
18
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%
Core plus Additional Tier 1 Capital (% of RWA)

Tier 1 plus Tier 2 capital (% of RWA)
12.3%
14.1% 19
Allocation of Deutsche Bank Capital

Corporate banking and securities Global transaction banking Asset and wealth management Private business clients Corporate investments Consolidation and adjustments Total 14,828 1,291 2,717 6,677 902 762 27,178
20
RAROC (page 503)
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
21
Example 23.5 (page 504)
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
22
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
23
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
24

Hull RMFI3 RD Ed CH 23

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Hull RMFI3 RD Ed CH 23

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Economic Capital and RAROC

A banks own assessment of the capital it requires

Model Used for Economic and Capital (Same as Regulatory Capital)

Loss over time horizon

The Basel II Regulatory Environment (Figure 23.2, page 493)

Non-Business Risk (regulatory capital):

Business Risk (no regulatory capital):

Credit Risk Market Risk Operational Risk

Risk from Strategic Decisions Reputation Risk

One-year Market Risk Gains/Loss Distribution (Figure 23.3, page 496)

One-year Credit Risk Loss Distribution (Figure 23.4, page 496)

Market Risk High

Moderate Moderate Moderate Low High High

Importance of Risks (page 497)

Most Important Risk Credit Risk

Asset Management Operational Risk

European Growth Trust (Example of

Operational risks can be contingent on market moves or credit events

Integrated Risk Management

Combining the Distributions

Example: Economic Capital Estimates (Table 23.2, page 500)

Market Risk Credit Risk Operational Risk

Total Economic Capital

Core plus Additional Tier 1 Capital (% of RWA)

Allocation of Deutsche Bank Capital

RAROC (page 503)

Example 23.5 (page 504)

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