Economic Capital & Allocation

Economic Capital

Four Principal Drivers of Economic Capital

The authors believe that there are four principal drivers of the amount of economic capital that companies should carry:

1. Capital in the ordinary course, i.e., steady-state capital

   The amount of capital that is required given a company’s VaR at a specified level of statistical confidence. The statistical confidence results from the model’s data parameterization period. Steady-state capital does not capture rare market events. To capture this issue, management needs to perform stress-tests.

2. Operational risk capital

   The authors define operational risk capital as the capital that is required to support losses that result from a company’s failed internal processes, such as losses that result from a failure to draft contracts tightly; losses that result from systems failures, etc.

3. Capital for adverse market movements—stress-tests

   The amount of capital that is required to sustain a company through severe market dislocations and volatility, also known as market events. We may know these events by names such as: October 1987, The Asian Crisis of 1997, or the equity market crash of 2001. The point is that these events are often not represented in the historical data parameters of the enterprise risk model—any model has this limitation. As such, these events need to be imposed on the model in order to learn what their impact would be on the company given the particular structure of its assets and liabilities.

4. Catastrophe risk capital

   The amount of capital that is required by a company to safely absorb losses that result from its catastrophe exposures.

Economic Capital as a safety net

• Economic Capital in ERM is the amount of capital required to provide a given level of safety over one year horizon
• The level of safety can be either linked to a Solvency Standard or to VaR at a confidence level

Capital Allocation

Capital allocation is another major subject where ERM may assist the management in making strategic decisions. The authors have used the Incremental VaR (IVaR) of a business line as opposed to the stand-alone business risk to allocate capital on what we call an “economic” basis. By economic basis of capital allocation (as contrasted with that of stand-alone business risk allocation), we mean that management should know where its capital is actually being allocated to support risk in contrast to how we advocate that individual business performance should be measured on a stand- alone basis. This is in keeping with our prior statement that individual business performance should not receive a credit that is not the result of its own activity. The use of IVaR for economic capital allocation purposes ensures that capital will be allocated on an economic basis to each business activity in proportion to the risk that each activity contributes to the total company risk. The stand- alone risk allocation of capital to business activities would not be appropriate for understanding the economic allocation since the sum of the individual stand-alone risks will be larger than the total risk of the enterprise owing to the correlations between the business sectors. As a result, the total required enterprise capital may be miscalculated.

From Risk Allocation to Capital Allocation

• ERM allocates a company’s capital to its business segments based on risk contributions of the segments to the company’s risk
• Risk Contribution is defined as a segment’s standalone risk reduced by the diversification benefit allocated to this segment
• Allocated capital for a segment is proportional to the risk contribution of the segment

Calculation of Risk Contribution / Attribution of Diversification Benefit

• Risk measure used in ERM for risk allocation follows industry standard VaR approach, but ERM is also able to allocate capital using any other measure of risk, including Tail VaR
• The Incremental VaR is the sensitivity of an enterprise risk to small changes in the segment sizes
• The Marginal VaR is the change of enterprise risk by adding/removing a segment to/from the company
• The sum of the Incremental VaR of the segments adds up to the total VaR of the enterprise
  1. The Incremental VaR is usually used for portfolio rebalancing
  2. The Marginal VaR can be used in M&A analysis
• The risk contribution by a segment is calculated as the incremental VaR of the segment