Managing Bank Capital

Role of Capital in Financial

Institution
Absorb large unexpected losses
Protect depositors and other claim holders
Provide enough confidence to external
investors and rating agencies on the
financial heath and viability of the
institution.

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Type of Capital

Economic Capital (EC) or Risk Capital.

An estimate of the level of capital that a firm requires to operate its
business.

Regulatory Capital (RC).

The capital that a bank is required to hold by regulators in order to
operate.

Bank Capital (BC)

The actual physical capital held

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Regulatory vs. Economic capital
• The goal of regulation is to set the regulatory
requirements in the way, that most reflects
the real risk the bank is facing.
• This shall lead to convergence of regulatory
and economic capital

Slide 4
Tier 1 Capital

Common Stock and Surplus

Undivided Profits
Qualifying Non-cumulative Preferred Stock
Minority Interests in the Equity Accounts of Consolidated
Subsidiaries
Selected Identifiable Intangible Assets Less Goodwill and
Other Intangible Assets
Tier 2 Capital

Allowance for Loan and Lease Losses

Subordinated Debt Capital Instruments
Mandatory Convertible Debt
Cumulative Perpetual Preferred Stock with Unpaid Dividends
Equity Notes
Other Long Term Capital Instruments that Combine Debt and
Equity Features
Capital adequacy ratio
b) Regulatory capital is used for the computation of
capital adequacy, the ratio of capital to the risks
undertaken by a given bank

CAPITAL
CAD   8%
RWA
CAD – capital adequancy
CAPITAL – total capital
RWA – risk–weighted assets

Capital adequacy ratio is one of the measures regulated

by the prudential rules and must be at least 8%.
Slide 7
Basel II
Pillar I - Capital Requirements
Basel I v/s Basel II

Basel: No Risk Differentiation

Capital Adequacy Ratio = Regulatory Capital / RWAs (Credit + Market)
8% = Regulatory Capital / RWAs

RWAs (Credit Risk) = Risk Weight * Total Credit Outstanding Amount

RWAs = 100 % * 100 M = 100 M

8% = Regulatory Capital / 100 M

Basel II: Risk Sensitive Framework

RWA (PSO) = Risk Weight * Total Outstanding Amount

= 20 % * 10 M =2M

RWA (ABC Textile) = 100 % * 10 M = 10 M

Total RWAs = 2 M + 10 M =12 M

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Economic Capital
Economic capital acts as a buffer that provides protection
against all the credit, market, operational and business
risks faced by an institution.
EC is set at a confidence level that is less than 100% (e.g.
99.9%), since it would be too costly to operate at the 100%
level.
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

The economic capital is the net value the bank

must have at the beginning of the year to ensure
that there is only a small probability of defaulting
within that year
Measuring Economic Capital :
The Confidence level
The time horizon: Market Risk / Credit Risk
Measures of Banking Risks
ECONOMIC CAPITAL
For example, an A-rated bank assumes a default
rate of around 0.1% (0.001) over the next year.
Of course, it is impossible to actually observe the
probability of default of a single bank.
Any single bank will either default or not default,
but by looking at the average default rate of all
banks in a given grade
it is possible to link credit ratings to the
probability of default.
 One basis
point=0.01%

(1)AAA-rated Bank will

default in the next year with
probability 0.01%
(2) On average, AAA-rated
bank can survive for 10,000
years(=1/0.01%)
(3) For the establishment of
economic capital, the bank
have to prepare enough
capital for achieving the
probability of 0.01%
 Introduction/Conceptual Clarifications

Economic capital is calculated by determining the amount of capital that

the entity needs to ensure that its realistic balance sheet (stated in market
value) stays solvent over a certain time period with a pre-specified
probability. It is often parameterized as an amount of capital that a bank
needs to absorb unexpected losses over a certain time horizon at a given
confidence interval (i.e. calculated as Value At Risk (VAR)) and it can
cover market risk, credit risk and operational risk.

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).

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 Conceptual Clarifications (Cont’d)

•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 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.
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 Conceptual Clarifications (Cont’d)

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.

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 Risk Measurement- Expected and Unexpected Loss

The Expected Loss (EL) and Unexpected Loss (UL) framework may
be used to measure economic capital
• Expected Loss: the mean loss due to a specific event or combination of
events over a specified period
• Unexpected Loss: loss that is not budgeted for (expected) and is absorbed
by an attributed amount of economic capital
Determined by Losses so remote that
confidence level capital is not provided to
associated with cover them.
targeted rating
Probability

EL UL
Cost

0 500 Economic Capital = 2,500

Expected Loss, Difference 2,000 Total Loss
Reserves incurred at x%
confidence level

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Economic Capital for Credit Risks
For the credit risk of lending operations, the
required economic capital (EC) depends on the
probability distribution of the losses (or the
distribution of asset value).
A typical probability distribution for credit losses
is sketched in the next slide. This sketch shows the
distribution of the value of the credit asset at the
end of one year
For single A-rated bank, the The unexpected loss or the standard error of loss:
probability=0.1%
UL=(0-EL)2X(1-4%)+(100-EL)2X4%

The expected loss

For example, if we assume a bank lend
out a money E=100 to a company and
the default rate of the company is 4%,
then EL=(1-4%)X0+4%X100

(1)The max. probable loss: if the loss is greater

than it, the bank will go to bankrupt
(2)If we can calculate EL, UL and know the
distribution of asset then we use EL and UL to
calculate MPL

The max. value of asset=there is

no loss for the credit asset
Economic Capital for Credit Risks

To conclude, several keys to calculate the

EC for credit risk
EL
UL
MPL
The distribution of loss value (or asset value)
Discuss them in detail in the following chapters
Economic Capital Framework

Slide 23
RISK-ADJUSTED PERFORMANCE
We have discussed methods for describing risk in
terms of required economic capital.
However, when deciding whether to carry out a
transaction, the bank is not only concerned about
the risk; it is also interested in profitability relative
to that risk.
By measuring risk-adjusted performance (RAP), a
bank can integrate risk measurement into the daily
profitability management of the business.
 Using Risk-Adjusted Performance to Make
Business Decisions
Risk-adjusted performance can be used to support the
following business decisions:
At the product level, to decide which products are
profitable and how products must be priced to
ensure that they are profitable.
At the relationship level, to show which customer
relationships are profitable.
At the transaction level, to decide whether to enter
into a transaction, and if so, at what price.
Using Risk-Adjusted Performance to Make
Business Decisions
At the individual or group level, to compensate staff
based on the profit they generate compared with the
amount of the bank's capital they consume.
At the business-unit level, to decide which units are
adding the greatest profit relative to the risks they are
taking.
Given this information, senior management can decide
which business should grow and which should shrink.
A typical finding is that high-risk, high-return
businesses, such as trading and commercial lending, are
less profitable on a risk-adjusted basis than the retail
lending.
Using Risk-Adjusted Performance to Make
Business Decisions

Traditionally, the banking industry relied on

measurements that gave an incomplete
picture of performance and its relation to
risk.
The two most common measurements
return on assets (ROA)
return on equity (ROE)
Using Risk-Adjusted Performance to Make
Business Decisions

ROA is the profit divided by the dollar value of

the bank’s total asset.
The asset is less sensitive to the risk
ROE is the profit divided by either book capital or
the bank’s regulatory capital.
The book capital is the net value of the bank as
measured by accounting methods.
The regulatory capital is the minimum amount of
capital that must be held by the bank according to
government regulators
Both of them are less sensitive to the risk
Using Risk-Adjusted Performance to Make
Business Decisions

Shortcomings of ROA and ROE

ROA takes no account of the risk of the assets
Even ROE uses the regulatory capital for considering
risk. However, the regulatory capital will be very
insensitive to risk
The tow risk-adjusted performance:
RAROC (risk-adjusted return on capital)
SVA (shareholder value added)
Based on economic capital, not regulatory capital
Economic capital is more sensitive to the risk a bank
has taken
Using Risk-Adjusted Performance to Make
Business Decisions
Risk-Adjusted Return on Capital (RAROC)
RAROC is the expected net risk-adjusted profit (ENP)
divided by the economic capital that is required to
support the transaction
Performance Evaluation: RAROC

RAROC
Expected Net Annual Income / Economic Capital
Expected Annual Net Income = Expected Annual net interest
income-expected annual operating costs- expected annual
losses (or loan loss provisions)- expected annual taxes
Hurdle Rate: Cost of Equity for the bank, CAPM
RAROC > Hurdle Rate; for a transaction/ business unit

Slide 31
Using Risk-Adjusted Performance to Make
Business Decisions

Hurdle rate (H)

Senior management normally sets a target for the return
it expects business units to make for using capital. This
minimum value for RAROC is called the hurdle rate
(H)
All transactions should be expected to pass over this
hurdle to be considered viable
The actual value chosen is around 12% to 20% and
depends on the return that the shareholders expect for
investing their capital in the bank
 Adopt RAROC as a common language

Revenues
What is RAROC ? -Expenses
-Expected Losses
+ Return on
economic capital
Risk Adjusted + transfer values /
Return prices
RAROC
Risk Adjusted Capital required for
Capital or Economic •Credit Risk
Capital •Market Risk
•Operational Risk

The concept of RAROC (Risk adjusted Return on Capital) is

at the heart of Integrated Risk Management.

33
Using Risk-Adjusted Performance to Make
Business Decisions

Taking a loan transaction as an example

The revenue for the bank
• the interest income on the loan: the initial loan
amount (A0) multiplied by the interest rate on the
loan (rA) +fees payment from borrower (F)
Using Risk-Adjusted Performance to Make
Business Decisions

the cost for the bank

• interest to be paid on debt + operating costs (OC)+
any losses (L)
• The interest to be paid on the debt is the amount of
debt (Do) multiplied by the interest rate on the debt
(rD)
• The amount of debt required is the initial loan
amount (A0) minus the economic capital (EC)
• Do = A0 -EC
Using Risk-Adjusted Performance to Make
Business Decisions

Once the hurdle has been set, it determines

how much the bank must expect to make on
each transaction for it to be viable.
If we replace RAROC with the minimum
value for RAROC (H), we can calculate the
minimum return required on a loan
transaction:
Using Risk-Adjusted Performance to Make
Business Decisions

Shareholder Value Added (SVA)

The 2nd risk-adjusted performance measure
It is simply the actual or expected profitability
minus the required profitability to meet the
hurdle rate.
The required profitability is the hurdle rate
multiplied by the economic capital required.
Based on the RAROC equations
Shareholder Value Added

Risk adjusted profit or Economic Profit

It is defined as earnings net of interest payment (funding
costs), taxes and provisions for specific loan losses, less a
charge for cost of equity capital (economic capital
multiplied by the hurdle rate)
SVA= Exp NII – Exp OC – loan loss prov – exp
taxes- capital charge
Capital Charge= Economic capital utilized by an
activity times banks hurdle rate

Slide 38
Product Pricing
Price of a product can be calculated using its
profitability as calculated by the risk adjusted
return on capital and amount of economic capital
attributed to it.
Break even price of the product = Expected
Annual interest expense + allocated annual
operating costs + expected annual losses + Capital
Charge

Slide 39