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

Capital Structure in Banks 215
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quarterly, much of the relevant data is (accurately) only available on
an annual basis. Therefore, the shortest, consistent time horizon is
annual. 384
As was shown in the market risk section, short holding periods and
the possibility of the quick liquidation of a position do not explain
the (accumulated annual) volatility of gains and losses in a bank’s
trading book. Since we can observe that the volatility in the annual
P&L is often greater than a daily or monthly VaR, it seems advisable
to use an annual (and more conservative 385 ) horizon for the quantification
of the risk in the accrued overall trading position.
Therefore, using the annualized deviation from the expected outcome
consistently across all types of risk, that is, setting H equal to one
year, is a fair way to compare the relative contribution of the sources of
risk to the bank’s overall return volatility.
Consistency of loss versus value-based approach: As was indicated above,
the ultimate distribution for determining economic capital is the distribution
of changes in the value of the underlying portfolio. However,
banks do not always have the information to compute the changes in
the riskiness, and hence the value of illiquid loans, on, for example, a
daily basis. At best, banks can acquire and evaluate such data on a
quarterly or, more commonly, on a yearly basis. Unless the bank has a
sophisticated mark-to-model method available to determine the value
of illiquid credits assets, no value changes can be calculated. Therefore,
the suggested EL/UL framework, which is consistent with the VaR idea
of estimating the distance between the expected and the unexpected
outcome, is the only way to determine an adequate proxy. Moreover, as
long as the lending book is not liquid, the loss volatility of the EL/UL
framework is a good estimate for the value volatility determined by a
mark-to-model methodology. 386 Besides, the results can be checked by
the suggested top-down approach as presented later in this chapter.
Consistent choice of the confidence level: As already mentioned, external
rating agencies use a one-year time horizon for their estimate of the
384 The caveat of this hypothesis is, however, that it assumes that all risks are eventually
fed through a bank’s P&L and are, therefore, reflected in the earnings distribution.
Vis-à-vis the (economic) return distribution, macroeconomic risks may only
show up with a large time difference.
385 Of course, extrapolating a one-day VaR to one year assumes that an institution
will not take any intervening steps if it incurs large losses.
386 For example, Garside (1998), p. 24, shows the difference between the economic
capital requirement of the two approaches basically diminishes to below 10% when
the confidence level is chosen high enough (i.e., higher than 99.95%).