Capital matters to most corporations in free markets, but there are differences. Companies in non-financial industries need equity capital mainly to support funding to buy property and to build or acquire production facilities and equipment to pursue risky new areas of business. But banks actively evaluate and take risks on a daily basis as part of their core business processes. It also is necessary to evaluate the impact of portfolio diversification and the degree of correlation among exposures on the bank's balance sheet.
To assess and manage risks, a bank must effectively determine the appropriate amount of capital that is necessary to absorb unexpected losses arising from its market, credit and operational risk exposures. In addition, profits that arise from various business activities need to be evaluated relative to the capital necessary to cover the associated risks. These two major concepts constitute the critical role of capital in the management of bank portfolios.
The challenge of determining economic capital lies in the fact that various risks a bank faces have a very different nature, are measured by different methodologies (if they can be quantified at all) and are difficult to encapsulate in one common metric. Given perfect circumstances, such a common risk metric would not only be able to capture and quantify all relevant risk exposures, it also would be able to account for all the correlations among different risk categories and exposures. This would allow individual estimates of unexpected losses to be aggregated into a statistically consistent unexpected loss distribution for the enterprise. In reality, economic capital frameworks within financial institutions are often very fragmented, and suffer serious deficiencies with respect to calculating aggregate risk from an integrated point of view.
Building an advanced economic capital framework assumes that banks find conceptual solutions to risk measurement, the definition of appropriate shareholder value metrics and the allocation of capital based on individual risk measures and their correlations. From an implementation point of view, economic capital frameworks imply key challenges in building comprehensive data structures and supporting technology as well as mastering significant cultural change. In practice, the cultural challenge and its implications for staff incentives and compensation is often one of the main causes for the failure of capital management projects.
Ideally, an integrated capital framework should not simply meet Basel II capital rules. It should have the potential to add significant value to a financial institution by allowing it to allocate economic capital to its risky portfolios and measure profitability against those allocations. In order to calculate regulatory capital, compare and benchmark against economic capital amounts and integrate risk analysis into both strategic and tactical decisions, institutions need sophisticated modeling and analysis capabilities. An appropriate system has to be able to handle stress testing and reporting for market disclosure while offering flexibility to model varied rules applicable in different national jurisdictions.
To meet Pillar 1 analysis and reporting requirements of Basel II, banks can gain considerable efficiencies from deployment of a flexible calculation engine, capable of working across multiple dimensions. The user should have the ability to modify formulae components at will, yet keep a 'locked-down' version for external reporting. Finally, it is vital the system transparently document every component of the underlying calculations for review by internal risk personnel, auditors and banking supervisors.
A further requirement of a system for the calculation of regulatory capital is the ability to perform stress testing based on Basel's Pillar 2 requirements relative to the IRB Approach. The system should support the simulation of a variety of credit-risk sensitive conditions over time, and also facilitate the integration of credit portfolio models and other internal economic capital models. A valuable functionality will be the ability to compare and contrast regulatory and economic capital in all relevant dimensions in a consistent and reconcilable way on a single platform.
The Pillar 3 requirements of the new Basel Capital Accord mandate regular publication of detailed disclosures covering all relevant portfolios within the bank, broken down in multiple ways and including qualitative information and quantitative data.
Satisfying the regulatory requirements of Basel II and building an economic capital analysis environment are different sides of the same coin and should not be viewed separately. Developing an advanced risk management capability and an economic capital framework is key to gaining competitive advantage from Basel II compliance efforts.
