Economic capital and the assessment of capital adequacy

RMA Journal, The, April, 2005 by Robert L. Burns

What will Basel II mean for community banks? This question can't be answered without first understanding economic capital. The FDIC recently produced an excellent analysis of economic capital and Basel II, which The RMA Journal is pleased to reprint. It is a must read for all community banks.

The assessment of capital adequacy is one of the most critical aspects of bank supervision. In completing this assessment, examiners focus on a comparison of a bank's available capital protection with its capital needs based on the bank's overall risk profile.

Bank management must likewise continuously evaluate capital adequacy in relation to risk. In recent years, many banks have adopted advanced modeling techniques intended to improve their ability to quantify and manage risks. These modeling techniques frequently incorporate the internal allocation of "economic capital" considered necessary to support risks associated with individual lines of business, portfolios, or transactions within the bank. As a result, economic capital models can provide valuable additional information that bankers and examiners can use in their overall assessment of a bank's capital adequacy.

As will be discussed later, economic capital models or similar risk and capital adequacy assessment processes are important to banks adopting the revised Basel framework. But revisions to capital regulations have not been the driving force behind the development of these models as such methodologies have been in use for more than 10 years at some of the nation's largest banks. Economic capital has also become a useful and sometimes necessary tool for other insured institutions. Several regional banks and some community banks have developed or are exploring implementation of economic capital models with more banks likely to do so in the future. This article provides an introduction to the concept of economic capital, describes the relationship between economic capital and the revised Basel framework, and discusses examiner review of economic capital models as a part of the supervisory assessment of capital adequacy.

Economic Capital

Economic capital is a measure of risk, not of capital held. As such, it is distinct from familiar accounting and regulatory capital measures. The output of economic capital models also differs from many other measures of capital adequacy. Model results are expressed as a dollar level of capital necessary to adequately support specific risks assumed. Whereas most traditional measures of capital adequacy relate existing capital levels to assets or some form of adjusted assets, economic capital relates capital to risks, regardless of the existence of assets. Economic capital is based on a probabilistic assessment of potential future losses and is therefore a potentially more forward-looking measure of capital adequacy than traditional accounting measures. The development and implementation of a well-functioning economic capital model can make bank management better equipped to anticipate potential problems.

Conceptually, economic capital can be expressed as protection against unexpected future losses at a selected confidence level. This relationship is presented graphically in Figure 1.

[FIGURE 1 OMITTED]

Expected loss is the anticipated average loss over a defined period of time. Expected losses represent a cost of doing business and are generally expected to be absorbed by operating income. In the case of loan losses, for example, the expected loss should be priced into the yield and an appropriate charge included in the allowance for loan and lease losses.

Unexpected loss is the potential for actual loss to exceed the expected loss and is a measure of the uncertainty inherent in the loss estimate. (1) It is this possibility for unexpected losses to occur that necessitates the holding of capital protection.

Economic capital is typically defined as the difference between some given percentile of a loss distribution and the expected loss. It is sometimes referred to as "unexpected loss at the confidence level."

The confidence level is established by bank management and can be viewed as the risk of insolvency during a defined time period at which management has chosen to operate. The higher the confidence level selected, the lower the probability of insolvency. For example, if management establishes a 99.97% confidence level, that means it is accepting a 3 in 10,000 probability of the bank becoming insolvent during the next 12 months. Many banks using economic capital models have selected a confidence level between 99.96% and 99.98%, equivalent to the insolvency rate expected for an AA or Aa credit rating.

The primary value of economic capital, and the reason that banks have already adopted such methodologies, is its application to decision making and risk management. Specifically, the use of such models can:

* Contribute to a more comprehensive pricing system that covers expected losses.

* Assist in the evaluation of the adequacy of capital in relation to the bank's overall risk profile.