Academic journal article Journal of Financial Management & Analysis

Value at Risk Model for Bank' Asset Allocation in Italy: Towards Effective Risk Management

Academic journal article Journal of Financial Management & Analysis

Value at Risk Model for Bank' Asset Allocation in Italy: Towards Effective Risk Management

Article excerpt


As everybody knows, the risk measurement and managing process* aims at the capital efficient allocation among the different units, division or business of a credit intermediary**. In order to reach this goal, further to measure and manage the different types of risk it can run, each bank has to develop a methodology for linking the capital allocation to the value creation. It is therefore necessary that the management fix a remuneration aim for the risk capital and allocate this last one to the activities / divisions generating a return, equal to or higher than the fixed aim, while those ones not reaching this aim should be analysed and, if necessary, abandoned***.

In order to reach an efficient capital allocation, the management must solve a lot of operative problems such as:

the quantity of capital that is possible to allocate among the different divisions / activities of the bank;

how to reconcile the allocation process with the exogenous constraints in the assets creation, imposed by the supervising authorities;

to define a reasonable profitability goal;

to define the guiding criteria for the al-location process;

to arrange an organisational structure suited to the risk management and allocation.

In addition to the operative decisions, this allocating process also implies strictly financial choices****. It is

important to underline that there isn't an optimal solution to the stated operative and financial problems, because every single credit institution has its own specific reality, which requires a specific attitude*. The allocation process of a credit institution is based on three different points. The first one consists in defining the available capital, aiming at identifying the ability to take a risk, the second one consists in identifying the capital cost, and finally there is the management's choice of the method to adopt for achieving an efficient allocation.

Definition of Assets Endowment

The definition of assets endowment of a credit institution depends, first of all, on the choice of the capital definition we intend to use. With reference to the Italian reality, among the different capital definitions for a credit institution, used both in literature and in practice, the following classification can be used3:

Reference Assets Threshold (RAT): it is the definition of the capital used by the supervising authorities for defining the requirements of the assets adequacy**4.

Accounting Assets (AA): it is the definition of the capital coming from the application of the accounting principles to the assets and liabilities positions of a bank.

Assets Market Value (AMV): it can be obtained by subtracting from the assets market value of the liabilities market value5.

Economic Capital (EC): this is the value obtained by the expected cash flows discounting, related to the activities carried out by a bank.

Capital at Risk (CaR)***: this is the value of the highest loss that can be realised, given a certain confidence range, by a bank in a given period of time.

The choice of the aggregates, most suitable to the use of the allocation process, is conditioned by the purposes lying at the basis of this process, which are summarised as follows:

to fix the limits, in terms of potential loss, to the operativeness of the business divisions of a bank;

to provide profitability goals to the different divisions, linked to the quantity of the allocated capital;

to maximise the profitability of the invested capital.

In order to reach these goals, it is necessary to compare the capital at risk to the capital really at disposal, which could be measured turning to the assets market value or to the economic capital****. …

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