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

Capital Structure in Banks 201
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expected losses, 323 the bank should either calculate an internal insurance
premium (similar to expected losses for credit risk) or should
buy insurance at a premium. For the remaining (small) probability
that event risks outside the three sigma range lead to larger losses,
the bank should hold economic capital (see below). 324
Banks should insure as much of the risk of experiencing major event
losses as they can. Even though buying insurance externally is frequently
perceived as expensive because of the direct and observable
costs that are associated with it, buying catastrophe insurance might
be the most appropriate way to hedge against event risk. 325 Despite
the fact that such catastrophe insurance for banks is more or less in
the early stage of development, 326 insurance companies now offer
mitigation options at competitive prices. 327 Therefore, the other
available option, to try and exploit the internal potential for selfinsurance,
seems to be less attractive but should be used where appropriate,
that is, where the market price is higher.
Assuming that a bank has insured itself up to its intended level and
has executed controls to the extent desired, the bank should hold
economic capital for the remaining part of its event risks; the derivation
of the amount of this economic capital will be discussed in
detail below.
The Derivation of Economic Capital for Remaining Event Risks As already mentioned,
event risk has no upside potential. Therefore, the methodology to determine
economic capital for event risk should be similar to the one for determining
economic capital for credit risk, especially with respect to the
fact that an event can occur with probability PE H
or not with probability
(1 – PE H
) at any time over the predetermined time horizon up to H. 328 In
a manner similar to that used in the credit risk framework, we can also
estimate the expected size of the loss at any time up to H and can, hence,
determine an expected loss (in dollar terms) for event risks (EL ER
). As for
323 One could also rate/score the underlying processes and calibrate them to probabilities
of occurrence (despite the fact that there is very little historical data to do
so), see Buhr (2000), pp. 203–205, and then determine expected losses and in a VaRlike
approach the required economic capital amount.
324 See Lam and Cameron (1999), p. 83.
325 See Damodaran (1997), p. 777, and Lam and Cameron (1999), p. 88.
326 Banks have only just realized the potential for large losses since they have been
trying to measure event risks.
327 See Wills et al. (1999), pp. 79–81 and 111.
328 Since we will use a consistent time horizon of one year, again we will drop time
index H from our discussion.