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Capital Structure in Banks 235 Assessment of the Suggested Approach We have introduced this new top-down approach for deriving economic capital because we wanted to check the results from the differentiated bottom-up measurement. We can observe that the difference between the reported and the inferred economic capital amount (via the newly suggested approach) is small (below 5%). 464 One is, therefore, tempted to conclude that the two approaches lead to very similar results and that one would be indifferent as to which one should be used. 465 However, Deutsche Bank does not report whether it considered correlations between the various types of risk to aggregate their bottom-up results to arrive at the final overall economic capital amount. If this is not the case, one can conclude that—since the top-down approach considers also macroeconomic risks and risks ignored by the three suggested bottom-up risk measurement approaches—the effects of ignoring the correlations and the risks that were unconsidered just canceled out. On the other hand, if correlations are considered in the aggregation process, we can then conclude that the bottom-up approach is fairly comprehensive and accurate. However, given that we have only two data points, neither of these two conclusions has to be the case. Likewise, we cannot conclude from the results that the capital requirement in the top-down perspective is (always) higher for Deutsche Bank than what is reflected in the bottom-up procedure, because the top-down approach uses market data that includes more comprehensive information than what the bank can estimate internally. 466 If such a difference can be consistently observed, the bottom-up results could then be used as a basis for reallocating the difference back to individual transactions. However, the above-derived results are heavily dependent on the input parameters. Since there were not enough data points available to calibrate the model to declare it robust, we are not able to conduct a full sensitivity analysis of all the input factors. However, when implementing the suggested approach, we found two effects worthwhile mentioning: 464 This obviously assumes that Deutsche Bank uses a one-year horizon for calculating capital requirements from the bottom up. However, according to anecdotal evidence, this is the current best practice approach in the banking industry. 465 Taking this line of thought to the extreme, and if one is only interested in the aggregate amount, one would conclude that a bank could save the costs and efforts of detailed bottom-up risk measurement. However, although it would avoid going through this hassle, the bank would not be able to understand the sources of its risks. 466 When implementing the model, we tested various other assumptions that lead to results being both higher and lower than what is published from the bottom-up procedure.
236 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS ■ ■ The final result is heavily dependent on V E as an input factor. Even though we can assume that the market assesses the bank’s risks fairly and that this is reflected in the current market value of the bank’s equity, we could observe that if V E becomes too low, economic capital can become negative. Or—turning this statement upside-down— the approach basically assumes that economic capital will always be smaller than V E . Given the discussion in the first section of this chapter, this does not necessarily have to be the case, at least from a theoretical point of view. Likewise, the estimated economic capital amount is fairly sensitive to changes in µ. Therefore, the assumption that it is equal to the weighted average return needs closer examination. 467 However, none of these statements is founded on solid ground, because we would need more than just two data points. Given that we estimated some of the input factors fairly roughly (from an external or regulators’ point of view), we can expect that the usage of internal knowledge would lead to further improvement and accuracy. The current version of the model only considers the capital requirement so that the bank has enough economic capital to avoid a bank run over the course of one (the next) year. Even though the model could be easily extended to horizons beyond one year, it would be difficult to interpret the results. On the one hand, we would not have (easily available) a calibrated benchmark for the probability of default on senior debt issues of the respective bank. On the other hand, the question is whether such a multiple-year estimate generates an accumulated capital requirement where one would need to back out the marginal capital requirement for each of the years via a more or less sophisticated approach. Evaluation of Using Economic Capital The advantage of VaR-based economic capital measures is that they are simple, forward-looking 468 summary measures of risk and allow for a consistent quantification 469 of total risk across all types of risk 470 and—in our 467 According to Crouhy et al. (1999), p. 11, this assumption and the numbers used in the example are in line with theory. 468 Since it is probability-based and calculated at the end of the measurement horizon H. 469 Note that even though economic capital is a good and adequate risk measure for banks, it is not a substitute for good risk-management decisions. It is rather only a necessary foundation. 470 See Culp and Miller (1998), p. 26.
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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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