Range of Issues and Practices in Economic Capital Modelling by Edu Pristine

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Edu Pristine

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... The Economic Capital Implementation Framework includes the following items: Defining Risk Measures ...

... more stable measure than Va R. However VaR is more easier to communicate. Challenges with using a particular risk measure are enumerated below. Standard Deviation ...

... on assumption of loss distribution. Not coherent as it violates subadditivity. Expected Shortfall – May or may not be stable depending on ...

... metric satisfies the subadditive condition. Confidence Level: Loss distribution for different types of risk have different assumed shapes ...

... an appropriate time horizon is important in making an accurate comparison ...

... a fixed diversification percentage from the overall total. Variance-Covariance matrix: Summarizes the interdependencies across risk types and a flexible framework for recognizing diversification benefits ...

... distribution with a joint probability distribution through a copula function. A more demanding input requirements and parameterization ...

... properties are being used and which are not. Qualitative review – Examine the documentation and the development work – The model should work in theory and take into ...

... be done before implementation. Management oversight: -Necessary to involve senior management in examining the output data of a model and knowing how to make business decisions ...

... by the bank should be replicable. This is rarely used: -Benchmarking and hypothetical portfolio testing – Commonly used – Benchmarking with a standard model, or comparing ...

... This can only be used if the model has a quantifiable metric. Not used by banks due to economic reasons ...

... impacted by the business cycle and can be explained by different models during recessionary or expansionary phases. If a bank uses a regulatory-approach then correlation estimates need to be estimated. Also assumptions should be consistent with the underlying assumptions of the ...

... Market-risk related challenges to counterparty exposure at default (EAD) estimation. These models combine all positions in a portfolio into a single simulation. Gains from one position may be offset by losses in another exposure. IT is necessary to compute ...

... the factor sensitivities of the bank's own exposures to the counterparty. Magnitude of wrong-way risk is difficult to quantify in an ...

... computer systems and specially trained people. Also there is a very high increase in the risk of measurement error. Quantification of operational risk is a significant challenge ...

... aggregated with high-level of market risk and operational risk measures in order to calculate economic capital. Counterparties need to be broken into detailed ...

... sheet and the need to model indeterminate cash flows on both the asset and liability side. Optionality in the banking book: A major challenge is with non-linear risk from long-term fixed income obligations with embeded options like prepayment risks ...

... based on probabilities and therefore difficult to integrate into economic capital models based on VaR – Not necessarily sensitive to current rate or economic environment – Does not take into account changes in slope ...

... of economic capital models in assessing capital adequacy – Bank should show how a model is used in its corporate decision making process ...

... The process should be very thorough to ensure that proper risk drivers, positions and exposures are taken into account in measuring economic capital. This ensures that there is little variance ...

... Risk Aggregation – Aggregation requires consistency in the measurement process – The methodology should mirror the bank's business composition and risk profile ...

... be used to cover all exposures: Aggregation process must be vetted prior to a bank having a big picture perspective of counterparty credit risk. Interest rate risk in the banking book ...

... portfolio context and not on a stand-alone basis. The loan's incremental risk contribution is used to determine the concentration of loan portfolio. Opportunities include the fact that it allows us to determine the appropriate hedging strategy ...

... marginally profitable customers. Economic capital can be used to maximize the risk return trade-off. Management Incentives: Compensation systems are a minor consideration in terms of the actual use ...

... Deviation: Very simple and not meaningful in risk decomposition process ii. Value-At-Risk: Not coherent because it violates the monotonicity condition iii. Expected Shortfall: Not stable as it depends on the loss distribution iv. Spectral and distorted Risk Measures: ...

... a specific RAROC. iii. In customer profitability analysis bank's use economic capital to maximize the risk-return trade-off. iv. Studies have showed that Management Incentives are a minor consideration when the adoption of economic capital measure in the business ...

... coherent because it violates the sub-additivity condition. 2.C. Along with a very demanding input requirement, parameterization is ...