LO 49.3: Explain benefits and impacts of using an economic capital framework

LO 49.3: Explain benefits and impacts of using an economic capital framework within the following areas: Credit portfolio management Risk based pricing Customer profitability analysis Management incentives
Credit Portfolio Management
Constraints imposed: Credit quality of each borrower is determined in a portfolio context, not on a stand
A loans incremental risk contribution is used to determine the concentration of the loan
alone basis.
Opportunities offered: The process allows one to determine appropriate hedging strategies to use in reducing
portfolio concentration.
Credit portfolio management becomes a means for protecting against risk deterioration.
Risk-Based Pricing
Constraints imposed: Pricing decisions are based on expected risk-adjusted return on capital (RAROC), so
deals will be rejected if they are lower than a specific RAROC. The proposed interest rate is determined by the amount of economic capital allocated to the deal.
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Topic 49 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
Pricing decisions include: (1) cost of funding, (2) expected loss, (3) allocated economic
capital, and (4) additional return required by shareholders. Therefore, a minimum interest rate is determined that will increase shareholder value.
Opportunities offered: Can be used to maximize the banks profitability. For example, some pricing decisions may need to be overridden because certain customer relationships are more profitable (at a lower price/interest rate) or desirable from a reputational point of view. Of course, such overrides are not taken lightly and require upper management approval, as well as rigorous subsequent monitoring.
Customer Profitability Analysis
Constraints imposed: The analysis is complicated in that many risks need to be aggregated at the customer
Customers need to be segmented in terms of ranges of (net) return per unit of risk; the
underlying information is difficult to measure and allocate.
Opportunities offered: Assuming that the measurement obstacles have been overcome, the analysis can be easily
used to determine unprofitable or only slightly profitable customers. Such customers could be dropped and economic capital allocated to the more profitable customers.
Economic capital is used in maximizing the risk-return trade-off (through relative risk-
adjusted profitability analysis of customers).
Management Incentives
Constraints imposed:
Studies show that compensation schemes are a minor consideration in terms of the actual uses of economic capital measures at the business unit level.
Opportunities offered:
It is suggested that management incentives is the issue that motivates bank managers to participate in the technical aspects of the economic capital allocation process.
B e s t P r a c t
i c e s a n d C o n c e r n s f o r E c o n o m i c C a p i t a l G o v e r n a n c e