Academic journal article Federal Reserve Bank of New York Economic Policy Review

Building a Coherent Risk Measurement and Capital Optimisation Model for Financial Firms

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Building a Coherent Risk Measurement and Capital Optimisation Model for Financial Firms

Article excerpt

I. INTRODUCTION

Risk-based capital allocation methodologies and regulatory capital requirements have assumed a central importance in the management of banks and other financial firms since the introduction of the Basle Committee's Capital Accord in 1988. However, as firms have progressively developed more sophisticated techniques for measuring and managing risk, and as regulators have begun to utilise the output of internal models as a basis for setting capital requirements for market risk, it is becoming increasingly clear that the risk as measured by these models is significantly less than the amount of equity capital that the firms themselves choose to hold.(1)

In this paper, we therefore consider how risk measures, based on internal models of this type, might be integrated into a firm's own methodology for allocating risk capital to its individual business units and for determining its optimal capital structure. We also consider the implications of these developments for the future approach to determining regulatory capital requirements.

II. WHY DO FINANCIAL FIRMS NEED INTERNAL RISK MEASUREMENT AND RISK-BASED CAPITAL ALLOCATION METHODOLOGIES?

The core challenge for the management of any firm that depends on external equity financing is to maximise shareholder value. To do this, the firm has to be able to show at the margin that its return on investment exceeds its marginal cost of capital. In the context of a nonfinancial firm, this statement is broadly uncontentious. If the expected return on an investment can be predicted, and its cost is known, the only outstanding issue is the marginal cost of capital, which can be derived from market prices for the firm's debt and equity.

In the case of banks and other financial firms, however, this seemingly simple requirement raises significant difficulties. In the first place, the nature of risk in financial markets means that, without further information about the firm's risk profile and hedging strategies, even the straightforward requirement to be able to quantify the expected return on an investment poses problems. Second, the funding activities of financial firms do not provide useful signals about the marginal cost of capital. This is because, for the majority of large and well-capitalised financial firms, the marginal cost of funds is indifferent to day-to-day changes in the degree of leverage or risk in their balance sheets. This, in turn, leads to a third problem, which is how to determine the amount of capital that the firm should apply to any particular investment. For a nonfinancial company, the amount of capital tied up in an investment can be more or less equated to the cost of its investment. However, in the case of a financial firm, where risk positions often require no funding at all, this relationship does not hold either.

It therefore follows that a financial firm that wants to maximise shareholder value cannot use the relatively straightforward capital pricing tools that are available to nonfinancial firms, and must seek an alternative shadow pricing tool to determine whether an investment adds to or detracts from shareholder value. This is the purpose that is served by allocating risk capital to the business areas within a financial firm.

III. RISK MEASUREMENT, SHADOW PRICING AND THE ROLE OF THE SHARPE RATIO

Since the objective of maximising shareholder value can be achieved either by increasing the return for a given level of risk, or alternatively by reducing the risk for a given rate of return, the internal shadow pricing process needs to be structured in a way that will assist management in achieving this objective. In other words, the shadow pricing tool has to have as its objective the maximisation of the firmwide Sharpe Ratio, since the Sharpe Ratio is simply the expression of return in relation to risk. Seen in these terms, we can draw a number of important conclusions that will assist us in determining how we should build our shadow pricing process. …

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