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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.
220 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS ■ ■ As described in detail, we can use the sophisticated, value-at-riskbased risk measurement models for market, credit, and operational risk to derive the total required economic capital for the bank in a bottom-up procedure. In order to do so, we would need data on a transaction-by-transaction level. 412 Since the aggregation of thusderived economic capital numbers is associated with difficulties in estimating the correct correlations between the various types of risk as well as substantial modeling risk (especially for operational risk capital), the results tend to be ambiguous. 413 Economic capital can be estimated from a top-down perspective using an approach based on option pricing theory. 414 We will present in this section a new version of this approach that uses the (future) development of the (market) value of a firm’s assets to model default risk. Since default occurs when the value of a firm’s assets falls so low that they are worth less than the firm’s liabilities, one can use this fact to estimate the probability of default. 415 However, in this section we will turn this approach upside-down. We will infer the probability of default from publicly available agency ratings 416 (for senior debt issues of the bank). We then use this estimate in combination with an assumed asset distribution to find the distance between the default point (i.e., is the critical threshold point of the asset distribution at the implied default probability) and the expected value of the assets. As we have seen, the distance (expressed in dollar terms) between these two points of the distribution is similar to a VaR-based estimate of economic capital. We will use this newly suggested top-down approach to check the results from the bottomup procedure. 412 Unfortunately, the complete set of such information is unavailable to bank outsiders for disclosure and competitive reasons and, hence, such an analysis cannot be provided in this book. 413 Additionally, often—according to anecdotal evidence—operational risk capital is estimated to match the difference between economic capital from other sources and the total of either book or market value of equity and is, hence, associated with relatively large uncertainty. 414 See Gupton et al. (1997), p. 59. Consulting companies such as Oliver, Wyman & Company can use their broad experience in the financial services industry and can use benchmarks for comparable financial institutions to derive reasonable top-down estimates of economic capital. 415 The leading commercial version of this approach is a model provided by KMV; see Gupton et al. (1997), p. 59. 416 From Standard & Poor’s (S&P) or Moody’s.
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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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