Economic Capital and

RAROC

Chapter 23

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John 1C. Hull 2012
 Economic Capital
A banks own assessment of the capital it
requires

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
2 Hull 2012
 Model Used for Economic and Capital
(Same as Regulatory Capital)
Figure 23.1, page 492
Expected X% Worst
1.2
Loss Case Loss

0.8 Capital

0.6

0.4

0.2 Loss over

time horizon
0
0 5 10 15 20 25 30 35 40
-0.2

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
3 Hull 2012
 Choice of Parameters
For a bank wishing to maintain a AA-
rating, 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.
4 Hull 2012
 The Basel II Regulatory
Environment (Figure 23.2, page 493)
Total Risk

Non-Business Risk Business Risk

(regulatory capital): (no regulatory capital):

Credit Risk Risk from Strategic

Market Risk Decisions
Operational Risk Reputation Risk

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
5 Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
6 Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
7 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.
8 Hull 2012
 Characteristics of Distributions
(Table 23.1, page 497)

Second Third Fourth

Moment Moment Moment
(Variance) (Skewness) (Kurtosis)
Market Risk High Zero Low

Credit Risk Moderate Moderate Moderate

Operational Low High High

Risk

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
9 Hull 2012
 Importance of Risks (page 497)

Type of Business Most Important

Risk
Commercial Credit Risk
Banking
Investment Market Risk and
Banking & Trading Credit Risk
Asset Management Operational Risk

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
10Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
11Hull 2012
 Interactions of Risks
LGD and PD
depend on
market value
Credit Market
Risk Risk

Operational risks can be

contingent on market
moves or credit events

Operationa
l
Risk

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
12Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
13Hull 2012
 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%
n n
Hybrid approach: E E E total ij i j
i 1 j 1

seems to work reasonable well

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
14Hull 2012
 Example: Economic Capital
Estimates (Table 23.2, page 500)

Business Business
Unit 1 Unit 2
Market Risk 30 40

Credit Risk 70 80

Operational Risk 30 90

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
15Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
16Hull 2012
 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?

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
17Hull 2012
 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
equal to x xE where xi is the size of
i
i

business unit i
Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
18Hull 2012
 Deutsche Bank Economic Capital
(millions of Euros) Table 23.4, page 503
Credit Risk 12,785
Market Risk 13,160
Operational Risk 3,682
Diversification benefits (3,534)
Business Risk 1,085
Total economic capital 27,178
Total risk-weighted assets 346,204
Core Tier 1 Capital (% of RWA) 8.7%
Core plus Additional Tier 1 Capital (% of RWA) 12.3%
Tier 1 plus Tier 2 capital (% of RWA) 14.1%

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
19Hull 2012
 Allocation of Deutsche Bank
Capital

Corporate banking and securities 14,828

Global transaction banking 1,291

Asset and wealth management 2,717

Private business clients 6,677

Corporate investments 902

Consolidation and adjustments 762

Total 27,178

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
20Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
21Hull 2012
 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

Risk Management and Financial Institutions 3e, Chapter 23, Copyright John C.
22Hull 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 0.01100 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.
23Hull 2012
 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.
24Hull 2012