Economic Capital, Performance Evaluation, and Capital Adequacy at Bank of America

Article excerpt

A case study of the economic capital system used by Bank of America reveals several basic principles shared by all economic capital frameworks and provides a practical illustration of how economic capital can work for any financial institution. This article begins with a discussion of the financial theory of allocating equity capital among different businesses for the purpose of evaluating business performance and capital adequacy. It then provides a detailed look at the measurement system itself, including each of the four different sources of risk--credit, country, market, and business that together determine the amount of capital assigned to an activity.

Institutions using economic capital methodology have coined the term to distinguish it from other measures of capital adequacy--in particular, regulatory and accounting concepts of capital. The term economic also encapsulates an ambition, like that of the dismal science, to describe and measure on a consistent basis the range of phenomena that drive a bank's risk/return decisions. A consistent and comprehensive economic model accomplishes two goals:

1. It provides a common currency of risk that management can use to compare the risk-adjusted profitability and relative value of businesses with widely varying degrees and sources of risk.

2. It allows bank management and supervisors to evaluate overall capital adequacy in relation to the risk profile of the institution.

With increasing dialogue among practitioners, regulators, and academics, best practices have gradually emerged, setting standards for calculation in most aspects of economic capital. Advances continue, especially in the areas of operational risk and consumer credit risk, but the overall field has matured to the point where supervisors have begun, with the upcoming implementation of the New Basel Capital Accord, to adopt and codify the industry's best practices in the regulatory capital framework.

Market Value Definition of Risk

Over the past decade, economic capital has steadily progressed toward market value models. Most commercial portfolio frameworks have by now discarded first-generation economic capital models based only on default risk, although these models persist in some cases for consumer portfolios. Given the goal of ensuring capital adequacy for a certain level of solvency, the volatility of market value is the best measure of a bank's risk and therefore its capital requirement.

Ultimately shareholders are interested in the total return on their investment in the bank's stock and its risk in market value terms. They compare the return earned on their investment to a required return based on its risk. Bondholders also care about market values. The value of their fixed-income investment is a function of the credit spread of the bank, the level of interest rates, and the expected cash flows of the debt. Since both stockholders and bondholders evaluate their investments based on market values, management should evaluate its opportunities with the same market value discipline. Defining risk in market value terms reinforces this discipline by aligning the interests of business managers with those of shareholders and bondholders.

The values of debt and equity are intimately related, as they are both derivative claims on the underlying assets of the company. According to the Merton model, the equity of a firm is equivalent to a call option on the firm's value, with the debt being the strike price. The equity holders have the option to "buy" the firm's assets and any other value of the franchise by repaying the debt. Equity holders will not exercise this option and will default on their obligation to the debt holders if the total asset and franchise value falls significantly short of the amount owed to creditors. The firm's leverage in market value terms (i.e., the difference between the market value of assets and the book value of liabilities) and the volatility of its market value are therefore the primary determinants of a company's default probability and required credit spread. …