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150 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
Note that many banks hold capital in excess 73 of the regulatory minimum
as an extra buffer 74 to avoid regulatory intervention 75 in the form of
“prompt corrective action” and the subsequent costs associated with increased
oversight and restricted business activities. 76
Required Capital from an Economic Perspective After discussing the regulatory
views on (equity) capital in some detail, we now turn to the economic
view on capital (requirements) in banks that focuses on its buffer function
against future, unidentified losses. 77 We depart here from the traditional
form of risk management of holding equity capital as an “all-purpose”
cushion for absorbing risk without the need to know the exact source for
the unexpected losses. 78 We have already identified hedging as an alternative
form of risk management—which is a very targeted means of limiting
risk, because the bank needs to specify exactly what kind and which quantity
of risk it is exposed to in order to determine the most suitable (financial)
risk-management instrument. However, once the firm has acquired the necessary
capability of measuring and quantifying its risks and decided to keep
some risks on its books, it can use this knowledge to tailor the capital requirement
to it—from a purely risk-based and insider’s perspective.
Before we turn to the detailed determination of the economically driven
capital requirement in the “Ways to Determine Economic Capital for Various
Risk Types in Banks (Bottom-Up)” section, we will discuss how the
various bank stakeholders’ interests can be aligned so that they can agree on
a single capital amount. We will then briefly discuss how the bank determines
whether it has sufficient capital funds to support the riskiness of its
portfolio of assets.
As we have already described above, the various stakeholders of a bank
have very different views on how much capital a bank should hold. These
different opinions can be best summarized in Figure 5.2.
Figure 5.2 depicts (in stylized form) the overall value distribution of a
bank, whose shape is determined by the riskiness of the bank’s assets. As can
73 Additionally, excess capital can be held as extra cushion for unexpected negative
shocks (see Berger et al. [1995b], p. 418), for lucrative new business (i.e., unexpected
profitable) opportunities, or for acquisitions.
74 Failure to meet these capital requirements will not necessarily result in default, but
will probably trigger regulatory intervention against the management of the group.
75 See Berger et al. (1995b), p. 403.
76 See Davis and Lee (1997), pp. 36–37.
77 However, Schmittmann et al. (1996), pp. 651 and 653, argue that equity is not a
cushion because all of the troubled banks in Germany over the past 50 years only
tapped into their equity resources to default at the same time.
78 See Merton (1995a), p. 464.