LO 48.1: Define, compare, and contrast risk capital, economic capital, and

LO 48.1: Define, compare, and contrast risk capital, economic capital, and regulatory capital, and explain methods and motivations for using economic capital approaches to allocate risk capital.
Risk capital provides protection against risk (i.e., unexpected losses). In other words, it can be defined as a (financial) buffer to shield a firm from the economic impact of risks taken. Should a disastrous event occur, those impacts could otherwise jeopardize the firms financial security and its ability to remain a going concern. In short, risk capital provides assurance to the firms stakeholders that their invested funds are safe. In most cases, risk capital and economic capital are treated synonymously, although an alternative definition of economic capital exists (discussed further in LO 48.3):
economic capital = risk capital + strategic risk capital
On the other hand, there are at least three distinct differences between risk capital and regulatory capital as follows: 1. Unlike risk capital, regulatory capital is relevant only for regulated industries such as
banking and insurance.
2. Regulatory capital is computed using general benchmarks that apply to the industry.
The result is a minimum required amount of capital adequacy that is usually far below the firms risk capital.
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Topic 48 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 17
3. Assuming that risk capital and regulatory capital are the same for the overall firm, the amounts may be different within the various divisions of the firm. From a risk capital allocation perspective, one solution is to allocate the greater of risk capital and regulatory capital to a certain division.
Professors Note: We w ill examine the regulatory capital charges fo r credit, market, and operational risk in the Basel readings later in this book.
Given that Basel III requirements are sufficiently robust, it is probable that in certain areas (e.g., securitization), regulatory capital will be substantially higher than risk/economic capital. Although the two amounts may conflict, risk/economic capital must be computed in order to determine the economic viability of an activity or division. Assuming that regulatory capital is substantially higher than risk/economic capital for a given activity, then that activity will potentially move over to shadow banking (i.e., unregulated activities by regulated financial institutions) in order to provide more favorable pricing.
Using Economic Capital Approaches
>From the perspective of financial institutions, the motivations for using economic capital are as follows:
Capital is used extensively to cushion risk. Compared to most other non-financial institutions, financial institutions can become highly leveraged (i.e., riskier) at a relatively low cost simply by accepting customer deposits or issuing debt. All of this may occur without having to issue equity. Additionally, many of the financial institutions will participate in transactions involving derivatives, guarantees, and other commitments that only require a relatively small amount of funding but always involve some risk. As a result, all of the firms activities must be allocated an economic capital cost.
Financial institutions must be creditworthy. A unique aspect of financial institutions is that their main customers are also their main liability holders. Customers who deposit funds to a financial institution will be concerned about the default risk of the financial institution. With over-the-counter (OTC) derivatives, the concern is counterparty risk. As a result, a sufficient amount of economic capital must be maintained to provide assurance of creditworthiness.
There is difficulty in providing an external assessment o f a financial institutions creditworthiness. It is challenging to provide an accurate credit assessment of a financial institution because its risk profile is likely to be constantly evolving. For example, an institution may engage in complicated hedging and derivatives transactions that could rapidly impact its liquidity. Therefore, having a sufficient store of economic capital could mitigate this problem and provide assurance of financial stability.
Profitability is greatly impacted by the cost o f capital. Economic capital is similar to equity capital in the sense that the invested funds do not need to be repaid in the same manner as debt capital, for instance. In other words, economic capital serves as a reserve or a financial cushion in case of an economic downturn. As a result, economic capital is more expensive to hold than debt capital, thereby increasing the cost of capital and reducing the financial institutions profits. A proper balance between holding sufficient economic capital and partaking in risky transactions is necessary.
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Topic 48 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 17
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