Bank Capital Management in the Light of Basel II
Rowe, David, Jovic, Dean, Reeves, Richard, Journal of Performance Management
Capital is key to any financial institution. Companies in other industries need capital to buy property and production equipment. For financial institutions, the primary function of capital is to cover unexpected credit and market risks losses, because risk of such losses inevitably accompanies a bank's core business of lending money and making markets. David Rowe, Dean Jovic and Richard Reeves explain why it is crucial for financial institutions to build an advanced economic capital framework and how that plays into current initiatives to implement the Basel II Capital Accord.
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 new areas of business. While this is also true for financial institutions, their main focus is somewhat different. Banks actively evaluate and take risks on a daily basis as part of their core business processes. For example, the commercial lending business inherently involves weighing the credit risk of new loans and their associated mitigates. This involves analysis of the credit quality of the underlying obligor, the effectiveness of guarantees, collateral, cross-default and other forms of credit protection. Today, however, best practice does not stop there. It also is necessary to evaluate the impact of portfolio diversification (e.g. in terms of geographical or industry concentration of exposures) and the degree of correlation among exposures on the bank's balance sheet. Another example is trading activity whereby a bank benefits from high trading volumes (by earning the bid/ask spread) and hopes to gain from proprietary net positions, but must bear some degree of market risk in the process.
Given the central role of market and credit risk in its core business, a financial institution's success requires that it be able to identify, assess, monitor and manage these risks in a sound and sophisticated way. The growing emphasis on the part of banking supervisors world-wide regarding adherence to best practice risk methodology reflects a broad recognition of how important such processes have become. In order to assess and manage risks, a bank must have effective ways to determine the appropriate amount of capital that is necessary to absorb unexpected losses arising from its market, credit and operational risk exposures. (Expected losses will be addresses through loan pricing and/or provisions.) In addition to that, profits that arise from various business activities need to be evaluated relative to the capital necessary to cover the associated risks (so called risk adjusted performance measurement or RAPM.) These two major links to capital - risks as a basis to determine capital and the measurement of profitability against risk-based capital allocations - explain the critical role of capital as a key component in the management of bank portfolios.
THE CHALLENGE OF DETERMINING ECONOMIC CAPITAL
So if you can measure risks, shouldn't it be straightforward to determine risk-based capital (commonly referred to as economic capital or risk capital)? And why are the two terms - regulatory capital (RC) and economic capital (EC) - so sharply distinguished?
The challenge of determining EC lies in the fact that all the various risks that banks are facing (market risks, credit risks, operational risks) have a very different nature, are measured by specific metrics (if they can be quantified at all) and are difficult to capture by one common metric or method. (The best candidate for a common metric is the value-at-risk approach). Given perfect circumstances, such a common risk metric would not only be able to capture and quantify all relevant risk exposures of the bank, it would also have to be able to account for all the correlations between different risk categories and exposures. …