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Capital Structure in Banks 211 Therefore, it appears not only appropriate but also a simple practical necessity to determine the correlations between the types of risk in a second step to thus aggregate the capital requirements for the overall bank level. This multistage correlation approach, 366 therefore, applies two correlation matrices: one within the risk type and a second one across the types of risk. However, it is even more difficult to determine the correlations for the second matrix. Therefore, in practice, these correlations are ignored altogether, and the aggregated capital requirements by risk type are simply summed to determine the overall amount. This obviously overstates the capital requirement as long as the correlations are smaller than one. This approach is often justified by the fact that banks want to create an extra capital buffer (for simple safety reasons) for all risks that are not quantified in any of the three types of risk. This seems to be especially valid, for example, for model risk, the risk that the measurement model itself is ill specified. On the other hand, some other banks try to determine the correlations for the second matrix by employing a macroeconomic simulation model. Despite its usefulness (especially when also modeling operational risks with it), this approach seems difficult to implement and will lead to a mistake 367 by ignoring some of the true correlations between transactions belonging to various types of risk. This is especially relevant when we try to disaggregate the capital requirement to the single transaction level. The overall, aggregated capital requirement at an average bank is typically split as shown in Table 5.3. 368 TABLE 5.3 Split of Economic Capital 1 Economic Capital Requirement as a Percentage of Overall Type of Risk Economic Capital Credit Risk 53% Market Risk 17% Operational Risk 30% 1 Note that the split of economic capital depends heavily on the chosen confidence level. 366 See Schröck (1997), pp. 73+, Buhr (2000), pp. 205+. 367 We are not trying to make a statement on how big that mistake is here. 368 See Wills et al. (1999), p. 92. These numbers are similar to the average of the observations in Drzik et al. (1998a), p. 25, who give the following (rough) split: credit risk: 53%, market risk: 20%, operational risk: 27%. However, the new Basle proposal (see Basle Committee on Banking Supervision (2001), p. 28, paragraph 161) indicates that banks hold on average only 20% of their economic capital for operational risk.
212 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS Concerns with the Suggested Bottom-Up Approach In this section we will discuss both the practical as well as the theoretical concerns when economic capital is calculated bottom-up according to the suggested approach. Practical Concerns As indicated in the introduction to this section, we will first discuss practical concerns such as the aggregation and allocation of economic capital, and the consistent application of the suggested bottomup approach. Aggregation and Allocation of Economic Capital The first and foremost concern with economic capital, calculated as described above, is that the incremental or marginal economic capital amount of a single transaction 369 in a portfolio context differs from the economic capital calculated for that transaction on a standalone basis (as long as the correlations are smaller than 1). 370 Since the latter approach obviously ignores any correlations, that is, any potential for diversification of the transaction to the rest of the portfolio, the sum of the standalone economic capital amounts overestimates the overall required capital amount at the portfolio level. When deciding on whether a transaction adds value to the overall bank, that is, making a marginal decision, obviously the marginal capital amount is relevant. 371 Therefore, considering the diversification benefits is crucial for determining the correct capital requirement at the bank level. However, this approach creates problems for the full allocation of all economic capital back to the constituting transactions. 372 This is so because the sum of the marginal amount of economic capital—calculated, for example, by the “with and without” approach—will result in too little capital as compared to the overall sum calculated at the portfolio level. Therefore, some of the overall required economic capital remains unallocated. And the amount of unallocated capital increases the smaller the correlations between the transactions are. Only in the extreme case, when the transactions are all perfectly corre- 369 The best way to determine that marginal economic capital is, as described previously, to calculate the economic capital requirement for a portfolio of transactions once with and once without the respective transaction (“with and without” approach). By building the difference of the two capital requirements at the portfolio level, we can determine the marginal or incremental capital requirement of the transaction under consideration. 370 Note that we have not calculated the standalone VaR in the previous sections. 371 See Merton and Perold (1993), p. 27. Note that for making other decisions on limiting and managing positions, the standalone economic capital may be more appropriate. 372 See Merton and Perold (1993), p. 27.
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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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