On Economic Capital and Capital Management
Guill, Gene D., The RMA Journal
Capital management, as practiced in financial institutions today, was develop in the late 1970s and early 1980s--a period of deregulation, increasing competition, rapid implementation of new technologies, and globalization. It was during this time that banks lost the regulatory protections that had ensured them the lowest relative cost of funds. Without these advantages and still prohibited from entering the securities markets, banks were drawn to seek out riskier corporate customers. Suddenly, the traditional "buy and hold" model of asset accumulation that had defined the commercial banking industry for generations was put under pressure. Ever since, banks have wrestled with the rediscovery of their economics. Key to this rediscovery is understanding risk and integrating risk and return into a consistent framework (for example, risk-adjusted return on capital, or RAROC) for business decision making.
Bankers Trust is widely credited with pioneering the development and implementation of capital management practices in commercial banking. As a new employee there in the late 1980s, I wanted to learn as much as I could about the abstract, statistical concept referred to as economic capital. I contacted a respected analyst within the bank and asked what he thought about economic capital. I was surprised to hear him say, "You can't trade it .... I'm not interested in it."
His response was completely at odds with the stated strategies of the bank, the discussions I had had during my interviews, and the culture that I had perceived within the institution. Nonetheless, I had to admit that he had a point, and I was left wondering whether economic capital was merely a conceptual idea or whether it was an estimated number useful in business decision making. I soon came to realize it was both a concept (a model) used to define the bank's approach to the market and an estimated number used in decision making. Furthermore, any gap between these two applications was due solely to our ability to quantify the concept at that specific point in time.
Thus, although the measurement of economic capital was a fertile research field for financial theoreticians and statisticians, the concept and the estimates of economic capital that were readily available were used up to the highest levels of the institution. …