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

Capital Structure in Banks 207
volatility of a bank’s residual business revenues and the (expected) value of
the “fixed” 348 costs. 349
Assuming then that (residual business) revenues are normally distributed
(as indicated in Figure 5.10) and that we are able to estimate the expected
value of “fixed” costs with reasonable confidence, we can determine
the required amount of economic capital for business risk as follows: Similar
to the above described approaches, we first determine the α-quantile of
the revenue distribution that is consistent with the bank’s chosen solvency
standard by calculating:
Φ -1 (1 – α) ⋅ σ ⋅E(Revenues) (5.36)
However, as also indicated in Figure 5.10, we do not need to hold
econom-ic capital for this full amount. Since the bank is only exposed to
(unexpected) losses, when the costs cannot be reduced below the identified
threshold level (within a reasonably short period of time), we can subtract
the difference between the expected revenues and this threshold level from
the capital requirement, so that:
Economic Capital for Business Risk
= Φ -1 (1 – α) ⋅ σ ⋅E(Revenues) –E(“Fixed” Costs) (5.37)
Despite the simplicity of this approach, it is heavily dependent on a sufficiently
long time series of historical accounting data. Directly analyzing
this data to estimate the business risk capital can be difficult due to the
adjustments that must be made to correct data for market and credit risk.
Additionally, the accounting data might be biased by the bank’s (current)
balance sheet policy, making it difficult to separate true business volatility
from purely accounting-driven P&L volatility. Moreover, this approach
assumes that historic trends will be continued. This approach, therefore,
only reflects the economic cycle and the changes in the competitive environment
inappropriately. To adjust for these caveats, the following approach
might offer solutions.
Monte Carlo Simulation Approach Even though this approach also relies
heavily on historical observations 350 to simulate potential future revenues
348 As already discussed, the amount of economic capital will be sensitive to the level
to which costs can be managed in response to revenue changes. Costs that are independent
of revenues should be considered as fixed, while costs that are directly
linked to the revenue volume should be considered variable.
349 Since these “fixed” costs will vary over time, we need to determine the expected
value for the period ending at time H.
350 Time series are also obtained over at least one business cycle.