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Capital Structure in Banks 219
tion), this measure is compatible with maximizing the expected utility and
with the assumption of risk-averse investors.
Therefore, some authors 409 suggest that this measure is more suitable
both for risk management and from a regulatory perspective. Even though
tail conditional expectations are more complicated to calculate, they do not
require more input data than the calculation of VaR-based economic capital
measures. However, the difficulty is that they cannot be as easily calibrated
to an external benchmark as VaR-based economic capital measures. Additionally,
as we have shown previously, banks themselves are risk-neutral in
the first place and only behave as if they were risk-averse because of financial
distress costs. 410
On the contrary, (risk-averse) investors are indeed not only interested in
the probability but also in the severity of such a lower-tail event. However,-
again, banks are different in this respect. Almost all of the customers’ deposits
are insured and almost all of the negative events following the threat of
a bank run are avoided by regulatory intervention. Therefore, one could
argue that most of the stakeholders 411 do not really have to care about the
severity element and are only interested in the probability (i.e., the threat of
this lower-tail event happening). Nonetheless, (junior) debt holders in particular
really care about severity as much as they do about the probability
of a lower-tail event hitting their tranche.
Despite the practical and theoretical concerns discussed previously, economic
capital is a useful and practical measure for total risk in banks. The
danger that any of these concerns will lead to problems can be avoided
by checking the results calculated from the bottom up by another method,
such as the Merton, or top-down approach, which we will discuss in the
next section.
Suggestion of an Approach to Determine
Economic Capital from the Top Down
While the other capital measures (Tier-1 capital, book capital, and market
capitalization of the bank’s outstanding stocks) are directly observable, we
need to estimate the fictional capital measure economic capital. As we have
seen, since the bank cares about total risk and tries to avoid financial distress
situations, we need to use a downside risk measure in order to derive
economic capital at the corporate level. There are two ways to do this:
409 See, for example, Guthoff et al. (1998) and Artzner (1999).
410 This is not the same risk aversion assumed in a traditional CAPM world.
411 Deposits are usually the largest source of funds in a bank, see, for example, Davies
and Lee (1997), p. 33.