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

208 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
and cost levels, 351 it does not depend as heavily on adjusted P&L data as the
previously described approach. Additionally, the Monte Carlo model has
the advantage that it can link the input parameters volumes and margins (to
model revenues) as well as fixed and variable costs to a proper macroeconomic
model. By doing so, the simulation approach is able to consider the
correlations between these input parameters as well as their interrelationship
to the way that market- and credit-risk-driven gains and losses will
develop over the projected time horizon in the context of the projected
business environment. 352 Moreover, we are also able to consider (fundamental)
changes in the competitive environment and the marketplace in such a
model.
Since all of these influencing factors, and especially their common
movement, can be modeled much more accurately than can be reflected by
just historical observations of accounting data, we can estimate both the
distribution of “net” business revenues and the threshold level of “fixed”
costs with more confidence. 353 To determine the required economic capital
for business risk at the desired solvency standard of the bank, we can follow
the previously described procedure exactly and determine first the α-quantile
of the revenue distribution and subtract the simulated, most likely level of
“fixed” costs from that amount.
Both of the approaches previously described provide a similar route to
determine the required capital amount for business risk. However, it can be
helpful to use a combination of the two approaches in order to make best
use of the available data. Additionally, the results of either of the two approaches
could be compared to the capitalization of companies observable
in the market. 354 This approach is especially helpful when bank data does
not supply sufficient information to determine the requirement for business
risk capital. Market data of nonbanks engaged in banking-related activities
can fill this gap. Besides addressing the difficulty that we then need to assume
that observable book or market capital equals required business risk
capital, a number of other assumptions must be met. The analogue company
must:
351 If data available are sufficiently granular, this approach can also be applied directly
at the business unit level.
352 For instance, we could model the impact of the economic conditions on (expected)
credit performance, and hence losses, or the impact of shifts in the interest rate curves
on the treasury result.
353 Of course, the quality of the model is dependent on the stability of the business
and the quality and quantity of the data available. This requires proper adjustments
for growth, economic cycles, and other factors such as inflation.
354 Therefore, often called “market analogues.”