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Capital Structure in Banks 215 ■ 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%).
216 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS default probability of a bank’s senior debt. We use this data point as the only objectively observable calibration point of our confidence level, which allows us to anchor economic capital requirements on an absolute basis. We apply this confidence level consistently across risk types. The difficulty, however, is to determine the senior debt confidence level of the various distributions. Often, as a shortcut and as a conservative estimate, the 99.97% confidence level (for a AA-rated bank) of the overall distribution 387 under consideration is taken. This might also be the only practical way to determine the economic capital requirement, because breaking down the senior debt confidence level to a single transaction/ subportfolio level might just be impossible. Other General Concerns As mentioned, the approach of basing the economic capital estimate on the asset distribution is based on the assumption that the bank’s liabilities are fixed and not contingent. Otherwise, we need to consider the distribution of net assets, which can easily lead to the result that no economic capital is necessary. 388 The approach just presented concentrates on financial risks. Therefore, it mostly ignores the relevance of a fundamental change in the macroeconomic environment that leads to a change in one or more of the relevant risk factors. For instance, a significant change in the dollar exchange rate can indicate a fundamental shift in the business conditions for banking in North America, for example, decreasing the fee income. Another example would be the impact of a serious event risk hitting an organization and leading to a dramatic disruption of its business. Unless the submodeling for each of the three types of risk is not linked to a proper macroeconomic model, these risks will be ignored in the suggested framework. However, as we will present shortly, the top-down approach implicitly includes the market’s perception/ information on all of these interdependencies, so it will usually lead to a higher result than the bottom-up procedure and can therefore provide a useful benchmark. 389 387 This basically ignores the discussion that the critical threshold should be determined at a confidence level of the senior debt tranche thereof. 388 Even though we do not consider insurance risk in this book, this is exactly what can happen there: Many insurance liability payoffs are contingent on the asset management’s performance (except for a minimum guaranteed return). Therefore, the presented asset approach will lead to false results. 389 Of course, to get to a final evaluation of such a general opinion, banks would have to publish more detailed information on their economic capital numbers. The third pillar of the new Basle Accord (see Basle Committee on Banking Supervision [2001], pp. 33+), which is market discipline, should greatly help in that respect.
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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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