Company Valuation Under IFRS : Interpreting and Forecasting ...

Chapter Six – The awkward squad
3.4 Economic capital
Many major European companies provide interesting and detailed disclosures
regarding their risk management activities. Most of this information is driven by
the regulations outlined above. We stated earlier that the objective of these rules
is to provide protection in the financial system given the hugely important role
played by financial institutions generally and large banks in particular.
In addition to meeting the ‘external’ regulatory requirements many financial
institutions will have their own internal checks, for example internal mechanisms
for allocating capital. Capital allocation decisions are important – the higher the
allocated capital the higher the buffer provided against any deterioration in the
business. Of course banks will also want to allocate capital as efficiently as
possible because there is a cost attached to it. Given that much of the discussion
in this text has surrounded economic capital approaches to valuation and analysis
it will not surprise you to find that it can also have a role here.
Management of a financial institution would first define and model a measure of
economic capital that is relevant for their business. Typically this would take the
form of ‘invested capital’ subject to the various adjustments to reported
accounting information that are normally required for the calculation of invested
capital. Then the allocation decision is made taking into account the various risks
of the business units (credit, market, operational, insurance etc). The
performance of these businesses can then be measured by using economic profit
rather than accounting profit. Remember the crucial difference between the two
is that economic profit includes a charge for capital, something that is absent
from its accounting equivalent. In an industry where capital is a scarce resource
this charge is of crucial importance. The charge tends to focus and mould the
minds of management when making decisions about where these limited
resources should go.
Barclays includes a very useful table of their economic capital allocation by
business (see Exhibit 6.9).
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