# LO 38.5: Distinguish between regulatory and economic capital, and explain the

LO 38.5: Distinguish between regulatory and economic capital, and explain the use of economic capital in the corporate decision making process.
Regulatory capital requirements may differ significantly from the capital required to achieve or maintain a given credit rating (economic capital). If regulatory requirements are less than economic capital requirements, then the firm will meet the regulatory requirements as part of its ERM objectives, and there will be no effect on the firms activities. However, if regulatory capital requirements are greater than economic capital requirements, then the firm will have excess capital on hand. If competitors are subject to the same requirements, this excess capital will amount to a regulatory tax. If competing firms are not subject to the excess capital requirement, they will have a competitive advantage. Because regulatory capital requirements are typically based on accounting capital, rather than economic capital, a firm with economic values in excess of accounting values may be penalized, and may have to maintain higher amounts in liquid assets to cover the shortfall.
The economic capital of the firm must be put to productive use. If a firm accumulates excess economic capital that is not employed productively, investors will reduce the value of the firm. This reduction will be consistent with the failure of existing management to earn the cost of capital on the excess amount.
As a firm takes on new projects, the probability of financial distress increases. One way to offset this increased risk is to raise enough additional capital to bring the risk of financial distress back to the level that existed prior to the new project.
For example, assume that a firm has a value at risk (VaR) measure of $1 billion. As a result of a new expansion project, assume the VaR figure increases to$1.1 billion. In order to offset the risk of the new project, the firm would need to do the following: 1. Raise additional capital of $100 million. Invest this additional capital without increasing the overall risk of the firm. 2. If the cost of the additional capital is 6%, and the new project is expected to last one year, then the new project would need to generate an additional$6 million to maintain the economic capital of the firm. Looked at another way, the expected benefit of the new project should be reduced by \$6 million to compensate for the incremental risk to the firm.
These decisions regarding how the risk of new projects will affect the total risk of the firm are further complicated by the correlations of the expected returns of the projects. If two new projects are less than perfectly correlated, the incremental increase in total risk will be less. One way to account for any possible diversification benefits is to reduce the cost of capital of projects that are expected to have lower correlations with existing operations.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
R i s k s t o R e t a i n a n d R i s k s t o L a y o f f
Many risks can be hedged inexpensively with derivatives contracts. Examples include exposures to changes in exchange rates, interest rates, and commodities prices. Rather than face the risk that unexpected cash shortfalls due to these exposures might negatively affect the ability of the firm to carry out its strategic plan, the firm should hedge these exposures.
Other risks cannot be inexpensively hedged. These are risks where the firms management either has an informational advantage over outsiders or the ability to manage the outcome of the risk-taking activity. A counterparty to a transaction that hedges such risks would require very high compensation to be willing to take on the transferred risks. The firms business risks fall into this category.
The guiding principle in deciding whether to retain or layoff risks is the comparative advantage in risk bearing. A company has a comparative advantage in bearing its strategic and business risks, because it knows more about these risks than outsiders do. Because of this informational advantage, the firm cannot transfer these risks cost effectively. Moreover, the firm is in the business of managing these core risks. On the other hand, the firm has no comparative advantage in forecasting market variables such as exchange rates, interest rates, or commodities prices. These noncore risks can be laid off. By reducing noncore exposures, the firm reduces the likelihood of disruptions to its ability to fund strategic investments and increases its ability to take on business risks.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
Ke y C o n c e pt s
LO 38.1 Enterprise risk management (ERM) is the process of managing all a corporations risks within an integrated framework.
The macro benefit of ERM is that hedging corporate diversifiable risk improves managements ability to invest in value-creating projects in a timely manner and improves the firms ability to carry out the strategic plan.
The micro benefit of ERM requires decentralizing risk management to ensure that each projects total risk is adequately assessed by project planners during the initial evaluation of the project. The two main components of decentralizing the risk-return tradeoff are consideration of the marginal impact of each project on the firms total risk and a performance evaluation system that considers unit contributions to total risk.
LO 38.2 The goal of risk management is to optimize (not eliminate) total risk by trading off the expected returns from taking risks with the expected costs of financial distress. Financial distress in this case is defined as circumstances where the firm is forced to forego positive NPV projects.
LO 38.3 The conceptual framework of ERM is a four-step process: Determine the firms risk appetite. Estimate the amount of capital needed to support the desired level of risk. Determine the optimal combination of capital and risk that achieves the target credit
rating.
Decentralize the management of risk.
LO 38.4 Due to diversification effects of aggregating market, credit, and operational risk, firm-wide VaR will be less than the sum of the VaRs from each risk category. This suggests that the correlation among risks is some value less than one.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
LO 38.3 Regulatory capital requirements may differ significantly from the capital required to achieve or maintain a given credit rating (economic capital). Because regulatory capital requirements are typically based on accounting capital, rather than economic capital, a firm with economic values in excess of accounting values may be penalized, and may have to maintain higher amounts in liquid assets to cover the shortfall. The economic capital of the firm must be put to productive use. If a firm accumulates excess economic capital that is not employed productively, investors will reduce the value of the firm.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
C o n c e pt C h e c k e r s
1.
2.
3.
4.
3.
Reducing diversifiable risk creates value: A. only when markets are perfect. B. because it is costly for shareholders to eliminate diversifiable risk through their
own actions.
C. because reducing diversifiable risk mitigates the underinvestment problem that can occur when investors have imperfect information about the firms projects.
D. only when it results in a permanent reduction in cash flow.
Effective enterprise risk management includes all of the following except: A. centralized evaluation of every projects risk. B. a project is only accepted if its return is adequate after considering the cost of
the projects contribution to total firm risk.
C. the projects planners perform the initial evaluation of project risk. D. periodic evaluations of the performance of business units consider each units
contribution to total risk.
The goal of enterprise risk management (ERM) can best be described as maximizing firm value by: A. eliminating the total risk of the firm. B. minimizing the total risk of the firm. C. optimizing the total risk of the firm. D. eliminating the probability of financial distress.
In determining the relative importance of economic value compared to accounting performance in its enterprise risk management program, a firm should: A. rely on accounting performance because it will be more accurate. B. rely on economic value because it will be more accurate. C. base its decision on the input of project-level managers. D. base its decision on the objective of the ERM program.
Which risk is least likely to be beneficial for a company to layoff? A. Currency exchange rate risk. B. Business risk. C. Commodities price risk. D. Interest rate risk.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
C o n c e pt Ch e c k e r A n s w e r s
1. C When markets are not perfect (i.e., investors information about project values is
incomplete), the firm may not be able to raise funds on fair terms. For a firm faced with an unexpected drop in operating cash flow, this can lead to the underinvestment problem, where the company passes up valuable strategic investments rather than raise equity on onerous terms. The inability to fund strategic investments can result in a permanent reduction in shareholder value even if the cash shortfall is temporary. Hedging diversifiable risk mitigates the underinvestment problem and creates value, even though shareholders can eliminate diversifiable risk at low cost by diversifying their portfolios.
2. A Central to ERM is the idea that a decentralized approach to the evaluation of project risks focuses managers throughout the firm on the importance of properly considering the risk and return implications of projects.
3. C The goal of ERM is to optimize the total risk of the firm. Eliminating total risk is not
possible. Minimizing total risk would preclude accepting risky projects that would allow the firm to expand and maximize value. These risky projects will increase the probability of financial distress. The goal of ERM is to optimize the risk of distress relative to the potential returns from the risky projects.
4. D There are certain situations where either accounting values or economic values will more
accurately reflect the firms situation. The determining factor in choosing between economic values and accounting values is the objective of the program. For example, if the objective is maintaining a rating, based in large part on accounting numbers, then accounting numbers will assume more relative importance.
5. B A company has a comparative advantage in bearing its strategic and business risks because it knows more about these risks than outsiders do. The firm is in the business of managing these core risks. The firm has no comparative advantage in forecasting market variables such as exchange rates, interest rates, or commodities prices. These noncore risks can be laid off.
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The following is a review of the Operational and Integrated Risk Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
O b se r v a t i o n s o n D e v e l o pme n t s in Ri s k A ppe t i t e Fr a m e w o r k s a n d IT In f r a st r u c t u r e
Topic 39
E x a m F o c u s
This topic discusses the concept of a risk appetite framework (RAF). For the exam, understand the elements and benefits of an RAF, and be familiar with best practices for an effective RAF. Also, be able to identify metrics that can be monitored as part of an effective RAF. Finally, understand the elements and benefits of a robust risk data infrastructure as well as best practices relating to data aggregation.
R i s k A p p e t
i t e F r a m e w o r k