Magazine article The RMA Journal

Retail Economic Capital and Basel II

Magazine article The RMA Journal

Retail Economic Capital and Basel II

Article excerpt

This article discusses the aspects of economic capital that are pertinent to retail portfolios. Because Basel II Internal Ratings-Based (IRB) capital adequacy formulations are fundamentally EC models, the authors include relevant components of Basel II IRB formulations for retail wherever necessary.

Although retail and corporate portfolios of most U.S. financial institutions today are about the same size, management of these portfolios has been uneven. Best-practice banks have long been managing the risk in their retail portfolios by product category, customer score, and other segmentation, which has led to common standards and terminology. However, far fewer institutions use this information to compute retail portfolio economic capital (EC), and the methodologies that are in use to determine EC also vary much more among retail product categories than they do among commercial product categories. Thus, there are no common standards and terminology as yet.

The retail credit business generally is divided into several broad product categories: mortgages (purchased money), home equity loans and HELOC, auto loans and leases, student loans, boat and recreational vehicle loans, unsecured bank loans, and revolving credit cards. In the language of economic capital, each product category may be characterized as having a narrow band of loss given default (LGD) and a correlation.

Basel II deals with minimum regulatory capital rules for banks that are based on risk sensitivity and internal models. There is considerable convergence between banks' internal economic capital methodology and Basel II. The Consultative Paper issued in 1999 at the very beginning of the process did not have an explicit methodology for capital adequacy for retail portfolios. CP2, the Consultative Paper issued in January 2001, set forth capital adequacy formulation for retail portfolios, but many details were missing. A Working Paper issued in October 2001 provided details of the Standardized and IRB (Internal Ratings-Based) approaches. The risk weight curve was the same for all retail products. Another Working Paper issued in October 2002 introduced different risk weight curves (essentially different portfolio correlations) for three different product categories within retail. It also introduced correlation as a decreasing function of credit quality. CP3, issued in April 2003, incorporates these changes.

The Basics of Economic Capital

Economic capital is a common currency for measuring diverse financial risk. In the case of credit risk in retail lending, it captures the unexpected losses from a credit portfolio. The risk arises from the unexpected nature of the portfolio loss as distinct from the portfolio's expected loss (EL), which is considered part of doing business and covered by reserves and income. EC covers all unexpected events except the catastrophic ones, for which it is too expensive to hold capital. The most important conceptual difference between EL and EC is that the EL of a portfolio is simply the sum of the ELs for each of the constituent loans in the portfolio. In that sense, EL is similar to such variables as revenue and expense. But the same does not hold true for EC. EC in a portfolio has to take an important additional variable into account--correlation. Correlations can exist between default behavior of one loan and another (intraportfolio correlation) or between one portfolio and another (interportfolio correlation). Typically, intra-portfolio correlations are much lower for retail portfolios than for wholesale portfolios. Lower correlation means lower EC and, consequently, lower EC (for the same EL). Another way of saying this is that a retail portfolio is more diversified than a wholesale portfolio. This is at the root of the sometimes counterintuitive result that a portfolio may have a higher EL but a lower EC. For example, a highly granular portfolio of diversified customers' credit card loans may have an EL of 4. …

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