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Capital Structure in Banks 195 ■ ■ ■ ■ empirical distributions for changes in the portfolio value are not normal and show leptokurtosis, or fat tails. VaR is, therefore, a poor predictor of what can happen in crises 277 and should be supplemented by other measures such as scenario tests or stress tests. VaR relies on stable correlations between the market risk factors and the assumption that the portfolio remains unchanged until the end of time horizon H, that is, there is no management intervention and the associated closing of positions will occur. One might expect that any of the strict assumptions on which the derivation of VaR is based may be violated to one degree or another. In combination, these violations can have a significant impact on the overall market risk capitalization. Economic capital for a single transaction is attributed to its contribution to the annualized risk of the existing portfolio. The correlation with a broad market portfolio, which is typically used to derive the value of such a position, is ignored in that context. As we have seen in our previous discussion, if the bank simply scales the daily VaR (which assumes that the expected return equals zero) to a yearly horizon, it will overallocate economic capital to its market risks. However, due largely to data availability and computational power, daily VaR is measured and calculated at the end of each trading day. This obviously ignores the fact that intraday losses, that could lead to default, can occur. 278 Scaling such a daily VaR to a yearly horizon would then basically ignore intrayear defaults and, therefore, the particular path of economic capital consumption during the year. 279 The bank, however, wants to hold enough economic capital to ensure that it will remain solvent at a certain confidence level at any point in time and would monitor its default status continuously. Taking such intrayear losses into account leads to the allocation of a greater amount of economic capital, since one must now ensure not only that capital is not depleted at the end of the year, but also that it is never depleted at any point during the year. 277 Some practitioners, therefore, evaluate VaR in the following way: “when you really need it, it doesn’t work.” Also see Culp and Miller (1998), p. 26, who conclude that VaR has been of limited value in avoiding “disasters.” 278 This would only matter at the overall bank level and not for a single business unit. Unlike losses due to credit risk (which is an absorbing barrier in a Markov sense), one could always recapitalize a trading unit that could then run profitably again. 279 This assumes that default could only occur at the end of the year.
196 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS Therefore, the simple scaling (ignoring expected returns) of daily VaR may not overallocate capital and might just compensate for the extra amount of economic capital needed. 280 Operational Risk In this section we will first define what operational risk is. As we will see, operational risk can be split into event risk and business risk. We will, therefore, discuss the steps to derive economic capital for each of these types of risk and the problems related to the two approaches. Definition of Operational Risk Even though there is no universally agreed definition, 281 we define operational risk 282 in this book as the risk of experiencing unexpected (financial) losses due to failures 283 in people, processes or systems 284 and their (internal) controls 285 or from external (nonmarket or non-credit-risk) events 286 and a bank’s business strategy 287 /business environment. 288 These risks are common to all companies, 289 not just banks, and can lead to a bank’s default at any time between now (t = 0) and a predetermined period of time ending at time horizon H. 290 This definition goes beyond the reflection of only financial risks 291 in 280 This obviously depends on the way VaR is measured and calculated. 281 Operational risk is often described as “residual” risk, that is, any risk that is not due to credit (including transfer risk) or market risk; see Lam and Cameron (1999), p. 94. Even though this negative definition may have the advantage that it tries to capture all remaining sources of risk, it does not necessarily create an incentive to explore the specifics and (avoidable) reasons for operational risk. 282 Often other labels are used for operational risk: organizational, business, or residual risk. 283 This includes (human or technical) error, omissions, fraud, or failure to perform in a timely manner or damage to a bank’s franchise value in some other way by employees exceeding their authority or through their unethical or risky behavior. See Basle Committee on Banking Supervision (1998), p. 1. 284 See Cooper (1999), p. 6 285 See Buhr (2000), p. 202. The Basle Committee on Banking Supervision (1998), p. 1, expands this to the breakdown of the corporate governance system of a bank in general. 286 The Basle Committee on Banking Supervision (1998), p. 1, includes the failure of IT systems, fires, and other disasters under this label. Additionally, often changes in the legal and political environment as well as (natural) catastrophes and terror are included, see Buhr (2000), p. 202. 287 See Buhr (2000), p. 202. 288 See Wills et al. (1999), pp. 29–31. 289 See Lam and Cameron (1999), p. 81. 290 The time horizon, again, is typically chosen to be one year. For a discussion see below. 291 These risks are, according to Damodaran (1997), p. 777, mostly continuous risks.
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isk management and value creation i
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Copyright © 2002 by John Wiley & S
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preface From an empirical as well a
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acknowledgments No book is solely t
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x CONTENTS Goals of Risk Management
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xii CONTENTS Definition of RAROC 24
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xiv FIGURES Figure 5.5 Figure 5.6 F
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symbols ↑ ↓ α β i xvi Increas
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xviii SYMBOLS ln Natural logarithm
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abbreviations APT BIS bn bps CAPM C
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2 RISK MANAGEMENT AND VALUE CREATIO
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CHAPTER 2 Foundations for Determini
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Foundations for Determining the Lin
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eferences Aguais, Scott D., and Ant
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References 295 Blanden, Michael (19
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References 297 and Abuses,” Journ
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References 299 Froot, Kenneth A., a
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References 301 risiken aus Handelsg
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References 303 Investments in Stock
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References 305 Institute of Technol
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References 307 Sharpe, William F. (
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References 309 Wall, L.D., and John
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312 INDEX Approach (continued) top-
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314 INDEX Capital: Tier-1, 139, 146
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316 INDEX Credit: derivatives, 178,
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318 INDEX Expectations: homogeneous
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320 INDEX Incentive(s), 22, 33, 45,
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322 INDEX Managers, poorly diversif
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324 INDEX Overinvestment, 75, 79, 8
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326 INDEX Reserve(s) (continued) lo
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328 INDEX Risk, liquidity, 3, 165 R
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330 INDEX Sharpe ratio, 244, 252 Sh
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332 INDEX Value at risk (VaR) (cont
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