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Capital Structure in Banks 237
context of value creation—at a consistent time horizon. 471 They are, therefore,
measures that can be considered a common currency for risk across all
types of risk.
However, an implicit assumption in the calculation of economic capital
is that the portfolio of transactions under consideration is kept constant over
time until H, the end of the measurement period. This assumption was less
of an issue when VaR was first developed in the trading arena, 472 where
only very short horizons are relevant (often only hours or days). On the
contrary, practical experience shows that—at least so far 473 —credit portfolios
are kept fairly constant over time 474 and (still) constitute the bulk of a
bank’s risk exposure. It is also worthwhile to mention here that economic
capital calculated on VaR basis seems only appropriate for banks, because
only they are concerned about the reduction in the total value of their portfolio
of assets. Industrial companies, which are concerned about preserving
the level of cash flows to finance valuable projects, 475 should choose other
measures of total risk. 476
Yet another problem with economic capital is that it typically only
considers the risk contribution to the overall bank portfolio and not to the
broad market. It is, therefore, difficult to use it as the basis for the valuation
of assets. 477
SUMMARY
We have derived an adequate risk measure for the bank’s concern with total
risk in this chapter. Even though we identified risk capital as the most appropriate
measure, we concluded that (the shortcut measure) economic capital
is the only practical way to determine the economically based capital re-
471 We only suggested a framework to calculate the capital requirement at a one-year
horizon, H. Since value creation occurs multiperiod, we will have to extend this approach
beyond H below.
472 See Culp and Miller (1998), pp. 28–29.
473 Before the broad usage of credit derivative instruments that significantly increased
the liquefaction in the credit markets.
474 Even though credit portfolios grow over time, their riskiness hardly changes significantly
because of the consistent application of credit guidelines.
475 As described by Froot et al. (1993).
476 See Culp and Miller (1998), p. 35, or for a more extensive discussion, Stulz (2000),
Chapter 4.
477 Froot and Stein (1998a) suggest a mix of the two approaches, which we will address
below.