LO 49.4: Describe best practices and assess key concerns for the governance of an

LO 49.4: Describe best practices and assess key concerns for the governance of an economic capital framework.
The soundness of economic capital measures relies on strong controls and governance. Senior management is responsible for making sure these controls are in place and that governance covers the entire economic capital process. Adopting an economic capital framework will improve a banks capital adequacy, strategic planning, risk appetite documentation, and risk-adjusted performance measurement. In order for an economic capital framework to be effective it should include:
Strong controls for changing risk measurements. Comprehensive documentation for measuring risk and allocation approaches.
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Topic 49 Cross Reference to GARP Assigned Reading – Basel Committee on Banking Supervision
Policies for making sure economic capital practices follow outlined procedures. View of how economic capital measures apply to daily business decisions. Best practices for the governance of an economic capital framework cover: 1. Senior management commitment. The successful implementation of an economic capital
framework depends on the involvement and experience of the senior management group. They are one of the main drivers for adopting this framework.
2. The business unit involved and its level o f expertise. Governance structures differ
among banks. Some banks opt for a centralized approach where economic capital responsibilities are assigned to one function (e.g., Treasury), while others opt for a decentralized approach that shares responsibilities between functions (e.g., finance and risk functions). Each business unit within the bank will manage its risk in accordance with the amount of allocated capital. The responsibilities for allocating capital within business units will also vary among banks as will the flexibility to reallocate capital during the budgeting period.
3. The timing o f economic capital measurement and disclosures. Most banks will compute
economic capital on either a monthly or quarterly basis. Pillar 3 of the Basel II Accord encourages the disclosure of information about how capital is allocated to risks.
4. Policies and procedures fo r owning, developing, validating, and monitoring economic
capital models. Formal policies and procedures encourage the consistent application of economic capital across the bank. The owner of the economic capital model will usually oversee the economic capital framework.
Key concerns related to governance and the application of economic capital measures involve: 1. Senior management commitment. The level of management buy-in contributes to
the meaningfulness of the economic capital process. The senior management group must understand the importance of applying economic capital measures for strategic planning purposes.
2. The role o f stress testing. Many banks currently apply stress tests; however, using more
integrating stress tests will allow banks to better assess the impact of a stress scenario on certain economic capital measures.
3. Measuring risk on either an absolute or relative basis. Correctly interpreting economic
capital as an estimate of risk depends on either measuring the absolute level of capital or measuring risk on a relative basis. Some issues within this measurement concern include assumptions regarding diversification and management involvement as well as how the economic model captures risks.
4. Not using economic capital as the only measure that determines required capital. Most
banks align economic capital with external credit ratings. Shareholders desire profitability via lower capital levels while rating agencies encourage solvency via higher capital levels.
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5. Defining available capital resources. Currently, there is no definition for available capital among banks. Most banks adjust Tier 1 capital to determine available capital resources.
6. Transparency o f economic capital measures. Economic capital models are more useful for senior managers when they are transparent. Increased documentation will improve the validity of using the model when making business decisions.
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Ke y C o n c e pt s
LO 49.1 A multitude of challenges exist within the economic capital framework that involve: (1) defining risk measures, (2) risk aggregation, (3) validation of models, (4) dependency modeling in credit risk, (3) evaluating counterparty credit risk, and (6) assessing interest rate risk in the banking book.
LO 49.2 There are ten BIS recommendations that supervisors should consider to make effective use of risk measures.
LO 49.3 A number of specific constraints imposed and opportunities offered by economic capital exist within the areas of credit portfolio management, risk based pricing, customer profitability analysis, and management incentives.
LO 49.4 Best practices for the governance of an economic capital framework cover: (1) senior management commitment, (2) the business unit involved and its level of expertise, (3) the timing of economic capital measurement and disclosures, and (4) policies and procedures for owning, developing, validating, and monitoring economic capital models.
Key concerns related to governance and the application of economic capital measures involve: (1) senior management commitment, (2) the role of stress testing, (3) measuring risk on either an absolute or relative basis, (4) not using economic capital as the only measure that determines required capital, (3) defining available capital resources, and (6) transparency of economic capital measures.
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C o n c e pt Ch e c k e r s
1.
2.
3.
4.
3.
Which of the following risk measures is the least commonly used measure in the practice of risk management? A. Value at risk. B. Standard deviation. C. Expected shortfall. D. Spectral risk measures.
Which of the following aggregation methodologies is characterized by great difficulty in validating parameterization and building a joint distribution? A. Copulas. B. Constant diversification. C. Variance-covariance matrix. D. Full modeling/simulation.
Which of the following model validation processes is specifically characterized by the limitation that it provides little comfort that the model actually reflects reality? A. Backtesting. B. Benchmarking. C. Stress testing. D. Qualitative review.
Which of the following categories of BIS recommendations specifically refers to the need to consider using additional methods, such as stress testing, to help cover all exposures? A. Risk aggregation. B. Counterparty credit risk. C. Dependency modeling in credit risk. D. Interest rate risk in the banking book.
The use of which of the following items is meant more for protecting against risk deterioration? A. Risk based pricing. B. Management incentives. C. Credit portfolio management. D. Customer profitability analysis.
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C o n c e pt C h e c k e r An s w e r s
1. D Spectral and distorted risk measures are the least used of the four measures and are mainly of
academic interest only.
2. A Copulas have two notable disadvantages: (1) parameterization is very difficult to validate, and
(2) building a joint distribution is very difficult.
3. B With benchmarking and hypothetical portfolio testing, the process has its limitations
because it can only compare one model against another and may provide little comfort that the model actually reflects reality. All that the process is able to do is provide broad comparisons confirming that input parameters or model outputs are broadly comparable.
4. B There are trade-offs to be considered when deciding between the available methods of
measuring counterparty credit risk. Additional methods, such as stress testing, need to be used to help cover all exposures.
5. C Credit portfolio management is used as a means to protect against risk deterioration. In
contrast, risk based pricing is used to maximize the banks profitability; customer profitability analysis is used to determine unprofitable or only slightly profitable customers; and management incentives are used to motivate managers to participate in the technical aspects of the economic capital allocation process.
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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:
Ca pi t a l Pl a n n i n g a t La r g e Ba n k Ho l d i n g C o m pa n i e s: Su pe r v i s o r y Ex pe c t a t i o n s a n d Ra n g e o f C u r r e n t Pr a c t i c e
Topic 50
E x a m F o c u s
To protect the smooth functioning of bank holding companies (BHCs), the Federal Reserves Capital Plan Rule requires BHCs to implement an ongoing internal capital plan for thoroughly assessing and enhancing their capital adequacy under stress scenarios on a firm wide basis. For the exam, know the fundamental principles and key practices to develop and implement an effective internal control plan, including: risk identifications, model valuation and review, oversight and governance, contingency planning, stress testing and scenario designing, loss estimation and projections methodologies, and evaluating the impact of capital adequacy, including risk-weighted assets and balance sheet projections.
C a p i t a l P l a n R u l e

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