Risk Management and Value Creation in ... - Arabictrader.com

Capital Structure in Banks 169
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Estimating the distribution of value changes for the specific risk type
at the end of the measurement horizon H
Estimating the confidence level to the target solvency probability for
the institution
Measuring the difference between the expected outcome and the
chosen confidence level
Note that whereas VaR is typically calculated at a somewhat arbitrarily
chosen confidence level of the distribution (mostly 95% or 99%), we are
now adopting the above-derived industry standard for doing so. As mentioned,
this industry standard is called economic capital and scales the VaR
confidence level to the critical threshold level for avoiding a bank run by
determining what amount of capital is necessary to protect the bank against
adverse events. Economic capital is therefore a function of the riskiness of
the bank’s activities and the bank’s desired likelihood of solvency. 166
Therefore, we determine
p[(X H
– E(X H
)) ≥ economic capital] ≤ α% (5.3)
the probability that the distance between the expected (positive) outcome X
and the unexpected (negative) deviations E(X) will not exceed economic
capital, which guarantees a certain solvency, with α% at/until time H. 167
Note that we assume that we do not need to hold economic capital for the
positive expected return X H
that accumulates until the end of the measurement
period, 168 because it will eventually also be available as a buffer against
losses (see above), but that we need to hold economic capital for all risks,
including bank-specific risks.
By doing so, we accept that economic capital is—as has been shown—
a shortcut to adopting the full-blown economic perspective to determine
risk capital. However, economic capital seems to be the only realistic practical
way to determine the required amount of capital. Note that—unlike
VaR that takes some confidence level of the overall distribution—economic
capital quantifies risk at a confidence level of what matters most to banks:
securing the senior debt tranche with a certain probability.
So far, we have only provided a very general idea of how economic capital
is determined. We now turn to the specifics of quantifying economic capital
for each of the three broad types of risk for banks. Even though the “devil”
is in the details and the actual implementation of these approaches (which
166 This is indicated (objectively) by the credit rating of the bank’s senior debt.
167 Deviations may be due to losses, credit defaults, and so on.
168 As defined above, net of expected (credit) losses.