Economic capital: implementation practices and methodologies

RMA Journal, The, July-August, 2005 by Nicholas L. Hayes, Charles Monet

Good news for the industry: A recent study from RMA confirms far more commonalities than differences in economic capital implementation practices among leading institutions.

Recent developments in the use of economic capital as a management tool have been obscured by the activity surrounding revisions to the Basel Accord. But although it's true that adoption of economic capital may have been hastened by the pressures of Basel, its use as an everyday instrument is based on a deeper need.

Economic capital's value to management is that it provides a common vocabulary and set of metrics for managing risk across the entire enterprise. Elements driving adoption of this technology include management's realization of the following:

* Improved loss experience, especially in the credit sector, can reduce earnings volatility and therefore have a positive impact on share value.

* Modern Portfolio Theory can be applied to the management of risk in financial institutions.

* There is a competitive advantage to be gained from employing economic capital as a management tool.

Many of these elements have been addressed individually in earlier RMA research projects and publications, as well as in the literature. However, in 2004, a group of major banks participating in RMNs Global Risk Policy Round Table asked RMA to study the extent to which economic capital measures have been adopted by the group members and to see whether any commonalitics in definition and practice exist.

This study of implementation practices and methodologies assisted RMA in defining the scope of the research and in developing the questionnaire used to survey the participants.

The findings showed many areas of commonality in terms of approach. They are important both as an indicator of common practice among large, internationally active institutions and as a directional marker for future development. Methodologies differ among these firms, however, and underline the fact that it is too early to categorize "best practices." Therefore, RMA intends to repeat the survey to better identify and confirm these trends and common practices within the industry.

Definition of Economic Capital

There are two views on the definition of economic capital. Ten of the respondents define it in terms of extreme losses: on the order of 99.95%, with a one-year time horizon. This view is essentially the one adopted by regulators in the Basel II capital framework. Meanwhile, two respondents define economic capital in a "going concern" framework. In this view, the firm is subjected to a far less extreme stress loss and is expected to emerge from such stress with an unimpaired ability to conduct business.

There is a consensus that economic capital should include only unexpected losses. Only one firm includes expected future profitability, in some circumstances, as an element of economic capital.

Elements of Capital

Capital itself is defined by all respondents to include common equity. Two-thirds include preferred stock, while one-third include quasi-equity securities that count as Tier I capital. Almost all exclude from the definition senior and subordinated debt, loan loss reserves, hidden reserves, and expected future earnings. And 50% of respondents considered goodwill to be a reduction of available capital (while a third considered it an increase in economic capital).

Uses of the Economic Capital Framework

The application of economic capital as a management tool has proliferated in recent years. All institutions that participated in the survey report institution-wide use of economic capital for assessing capital adequacy and for profitability reporting. Some 92% of firms use the technology for strategic planning and resource allocation to businesses, while 75% use it in transaction pricing for credit products.

In contrast with the heavy use of economic capital for profit-center reporting, only a third of the firms report economic capital by country.

Most firms (75%) adjust business-unit profitability with a capital charge based on the level of economic capital. This practice is consistent with the economic value-added framework as put forth by Stern and Stewart. Most firms (75%) base the cost of capital (actually, the cost of equity) on the Capital Asset Pricing Model and use the same cost of capital for almost all business traits. Any variations that exist are based on the cost of capital of other firms in the same line of business, or differing risk-free rates for different businesses.

Despite the increased use of economic capital, only 25% of respondents use it for senior management compensation. Not surprisingly, even fewer firms use it to drive compensation for lower-level managers. This finding may indicate a lack of confidence in economic capital results: a belief that economic capital utilization is outside management control or questions as to the relevance of the measure at lower organizational levels.

What is clear from the findings is that economic capital has become the vocabulary of enterprise-wide risk management at these large institutions, despite variations in methodologies, and that the key definitional elements of tenor and confidence levels are common currency with them. The study findings next looked at the applications of economic capital across risk types--credit, market, and operational-and in business units.