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Basel II: A Closer LookManaging Economic Capital

2004 KPMG International. KPMG International is a Swiss cooperative of which all KPMG firms are members. KPMG International providesno services to clients. Each member firm is a separate and independent legal entity and each describes itself as such. All rights reserved.

Contents

1 Introduction

2 Understanding Economic Capital

4 The Business of Taking and Managing Risk

10 An Approach to Capital Planning

15 Capital Planning a Process Overview

19 Conclusion

20 Appendix I: Understanding Value at Risk (VaR)

25 Appendix II: Capital Allocation and Planning

29 Appendix III: Risk-Adjusted Performance Measurement

31 Appendix IV: KPMG Survey on the Use of Economic Capital

2004 KPMG International. KPMG International is a Swisscooperative of which all KPMG firms are members. KPMGInternational provides no services to clients. Each member firm is aseparate and independent legal entity and each describes itself assuch. All rights reserved.

Regulatory capital planning has always been an important aspect of banks

compliance activities. Now, however, economic capital planning is

becoming increasingly important to banks overall competitiveness and

with the new Basel accord, understanding and measuring economic capital

has also become a compliance obligation.

Economic capital is the capital banks set aside as a buffer against potential

losses inherent in any business activity corporate lending, for example, or

currency trading. Banks focus on economic capital is part of an industry-wide

movement to measure risks, to optimize performance measurement, to base

strategic decisions on accurate information, and thus to strengthen an

institutions long-term profitability and competitiveness.

In evaluating these issues, leaders are considering questions including:

Do we understand the nature and level of risk the bank is taking?

How much capital is needed to support the banks total risk? What is the

expected return on that capital?

Is the bank over or under capitalized in relation to its risks?

Are individual business lines creating or destroying shareholder value?

What are the major sources of concentration and diversification in our

portfolio? What opportunities for growth or diversification exist within

the bank?

How should the businesss capital be managed within constraints imposed by

regulators, investors, and rating agencies?

How do we improve our portfolio performance? Which exposures should we

buy or sell and in what quantities? What is an optimal strategy for

hedging/selling down risk?

Do we need better analytics to support our discussions with rating agencies

and thereby support our rating?

Although economic capital planning has been evolving for a number of years, it

has attained new focus and urgency as a result of the regulatory mandates of the

Basel II Capital Accord (Basel II). In the three-pillar framework, Basel II introduces

the concept of economic capital into the regulatory capital consideration by

requiring banks to determine capital adequacy based on the level of risk posed by

specific business activities. In emphasizing capital planning overall, Basel II

overcomes a substantial shortcoming of its 1988 predecessor, which did not

require banks to develop their own methods, processes, and systems to

measure the capital level adequate for the risks they assume.

This white paper emphasizes the importance of banks evolving efforts to

integrate economic capital planning into overall risk management. These efforts

can help banks build value in their businesses as well as comply with Basel II.

Jrg Hashagen, KPMG in Germany

Head of KPMGs Basel Initiative

Introduction

Basel II: A Worldwide Challenge for the Banking Business 1


Banks face a broad and evolving array of risks today (see Figure 6 on page

14 for an overview). Many banks have found that economic capital planning

helps them identify their risks, link those risks with particular business

activities, and, in the process, understand how and where they actually

generate shareholder value as well as how they could or should do so.

Although many banks have made progress, they continue to address

technical issues associated with economic capital management.

To this end, banks aim not only to calculate their business lines returns but also

their risks and associated economic capital levels. Thus they are able to measure

comparable risk-return profiles as well as risk-adjusted performance across all

business lines.

Basel II Provides New Incentive for Managing Economic Capital

Basel II has given new urgency to banks focus on managing economic capital.

By better aligning banking risks and their management with regulatory capital

requirements, Basel II provides a new incentive for banks to renew their risk

management efforts by developing a capital planning approach that integrates

regulatory and economic capital models into an overall framework. Moreover,

under Basel IIs Pillar 2, bank supervisors may require that a bank hold extra

capital if they find that its risk management framework is inadequate.

To comply with Pillar 2, banks will have to develop and use various models

(risk-specific and for economic capital management) to allocate capital to

business activities based on how much risk, and of what type, an individual

activity contributes to the banks portfolio of risks. These models would

determine how much capital is required to support the various activities of the

bank a purpose regulatory capital is not intended to serve for all activities, even

under the more risk-sensitive calculations of Basel II.

Realizing Business Benefits Beyond Basel II

The business benefits a bank can derive from such economic capital approaches

extend beyond Basel II compliance. Once risk-return profiles and risk-adjusted

performances are comparable across business lines, and measurable for the

entity as a whole, banks can address two key business objectives: 1) specify risk

profile to debt-holders and 2) generate value for shareholders.

This document discusses the evolving importance of economic capital planning

for banks. It addresses risk and its measurement and lays out a framework for

economic capital management. It describes how such an approach can help

banks achieve a variety of business benefits beyond Basel II compliance.

Understanding Economic Capital

2 Basel II A Closer Look: Managing Economic Capital


Distinguishing Regulatory Capital from Economic Capital

Measurement of regulatory and economic capital evolves from two types ofrisk management models banks have been developing and using for a number of years.1

The first model was designed in the 1980s for the needs of external risksupervision and regulatory reporting. It measures regulatory capital, theminimum amount of equity capital or other funds that the institution mustmaintain to comply with regulatory requirements (currently under Basel I and inthe future under Basel II, Pillar 1).

The second model evolved in the 1990s from the needs of risk and capitalmanagement. It measures economic capital, which the Basel Committeedefines as a measure of the amount of capital that a firm believes is needed tosupport its business activities or set of risks2 Economic capital typicallyfunctions as a common currency for risk, overcoming the inconsistencies in theregulatory capital adequacy framework.3

Economic capital measurement is part of a growing trend to aggregate risks andthen to integrate economic capital with regulatory capital planning. The BaselCommittee acknowledged the trend toward risk aggregation and elaborated onthe definition of economic capital in its August 2003 publication, The Joint Forum:Trends in Risk Integration and Aggregation. The Committee notes that:

The Basel Committee acknowledges that banks would not be likely to use asingle economic capital metric as the basis for decision-making but that such ameasure could be useful in bringing consistent discipline and input torisk-related decision-making.5

The Basel Committee also recognizes that many firms and their managementsrealize that economic capital results are one factor among several used inmaking decisions on risk control, the adequacy of firmwide capital, and theallocation of capital to the business lines. Furthermore, in no case does economiccapital supplant the firms existing risk management framework.6 The Committeenotes that because the use of economic capital models represents a significantcultural change for organizations, such use requires strong board andmanagement support.7

Figure 1 summarizes the differencesbetween economic capital andregulatory capital.

Source: KPMG International 2004

Basel II A Closer Look: Managing Economic Capital 3

1 Guido Giese, Economic capital versus regulatory capital a market benchmark, Special Report on Basel II, p. S17-S20,. In: Risk, vol. 6, no. 5 (May 2003).

2 Basel Committee on Banking Supervision. The Joint Forum: Trends in Risk Integration and Aggregation, August 2003, p. 21.3 Guido Giese, Economic capital versus regulatory capital a market benchmark, Special Report on Basel II, p. S17-S20,. In: Risk, vol. 6,

no. 5 (May 2003).4 Basel Committee on Banking Supervision. The Joint Forum: Trends in Risk Integration and Aggregation, August 2003, paragraph 24.5 Basel Committee on Banking Supervision. The Joint Forum: Trends in Risk Integration and Aggregation, August 2003, from paragraph 27.6 Basel Committee on Banking Supervision. The Joint Forum: Trends in Risk Integration and Aggregation, August 2003, from paragraph 37.7 Basel Committee on Banking Supervision. The Joint Forum: Trends in Risk Integration and Aggregation, August 2003, from paragraph 38.

The ultimate expression of the risk aggregation trend is the emergence ofeconomic capital methodologies that seek to aggregate multiple types of risksinto a single metric. Economic capital methods seek to assess the amount ofcapital needed to support a given set of risks. They are often based onstatistical methods, for example the amount of capital needed to absorblosses up to a specified probability (e.g., 99.97 percent). But in many casesthey also incorporate stress-test or scenario-based methods to measure theamount of economic capital that a firm could need to cover potential lossesthat would be associated with a given set of risks or activities.4

Economic capital is...

Anything that can absorb economic losses without affecting debt-holders

Not just book capital but may include intangibles and hidden reserves or charges

Necessary to absorb potential losses associated with any of the risks already assumed or to be assumed

Regulatory capital is...

Defined by regulators Inclusive of Tier 1 and Tier 2 capital and supplementary capital Meant to assure that a bank is able to

cover major potential losses without causing a banking crisis

Regulatory capital management helps to ensure the soundness and stability of the banking sector and

protect depositors

Economic capital management helps to identify value-creating business

activities to satisfy investors' information needs, and, with Basel II,

to fulfill regulatory requirements


Banking involves earning revenue from the calculated assumption and

management of risk. Ultimately, a banks lenders and investors expect the

banks management to take on calculated, well-priced risk so as to ensure

that loan capital is repaid with interest on a sustainable basis and that the

banks shareholder value is enhanced over the long term. Investors expect

that the greater the risk assumed by the bank and the higher their

personal share of the risk the higher their expected return will be.

Profitable banks are run by management teams whose responsibility it is to

actively seek out risk and to distinguish well-priced opportunities. To be

successful, they must continue to achieve an appropriate return on the risk taken.

To do so, they need to continually review the following questions:

What is risk, what kind of risks are generated by my business, and how can

we measure these risks consistently to make them comparable?

What is the price of risk in the market, and how can we identify risks the

bank should assume?

What is the right capital mix for our bank?

Does the bank have enough capital to support the risks it takes?

How can we derive an appropriate limit system for all risks and business lines

that ensures that the bank does not take on too much risk?

How can risk be integrated into a performance measurement and incentive

system that aligns employees economic interests with those of the bank?

In many cases, answering these questions would call for monitoring and even

redesigning the banks internal methodologies and processes.

Linking Risk to Capital

Risk measurement focuses on unexpected losses which generally arise either

through lower than expected returns from assets or as a result of having to pay

more than anticipated for liabilities. It is unexpected losses that lead to volatility

in the earnings of a bank ranging from lower profits to balance sheet losses

and, potentially, bankruptcy.

Different business activities lead to various unexpected losses. For example,

granting a 10-year fixed-rate loan leads to credit risk (the debtor may not

repay the loan), market risk (the interest rate may change), and operational

risk (inadequate processes result in incorrect collection of interest payments).

To link risk with capital, these different risks must be measured individually and

aggregated to a single risk metric, both by business line and across the bank

as a whole. Moreover, even in the case of rare but likely events that might

generate unusually high unexpected losses (e.g., as in some past market

crashes), the banks capital must be high enough to ensure the viability

of the institution.

The Business of Taking andManaging Risk

4 Basel II A Closer Look: Managing Economic Capital

Issues and Challenges

Linking risk to capital requires:

Identification of all material

risks and measurement of

these risks on the basis of

defined methods including

back-testing (validation of risk

measures by comparing past

unexpected losses/gains

with real outcome) and

stress-testing (measurement

of risks for specified

extreme events)

Aggregation of all risks for

business lines and for the bank

as a whole

Specification of the risk-taking

capacity and the tolerance for

risk (i.e., definition of target

rating and the amount of

equity that will serve as

economic capital)


From the debt-holders point of view, a banks equity capital acts as a cushion

against any unexpected losses: debt-holders have to take such losses only when

their total exceeds the banks equity capital.

From an economic rather than an accounting point of view, the same principles

apply. However, instead of balancing book values and write-downs against book

capital, management must weigh unexpected downside changes in the economic

value of assets and liabilities against economic capital. The latter is the economic

counterpart of book capital everything that can absorb economic losses without

affecting debt-holders. It therefore usually includes not just book capital but also

expected future profits or losses and other reserves and provisions.

Apart from business needs, Basel II also requires that banks implement an

economic capital management framework that assesses the overall capital

adequacy in relation to their risk profile and a strategy for maintaining their capital

levels.8 Figure 2 shows the elements of linking risk to capital.

Figure 2: Linking Risk to Capital

Source: KPMG International 2004

Basel II A Closer Look: Managing Economic Capital 5

8 Basel Committee on Banking Supervision. Revised Framework of International Convergence of Capital Measurement and Capital Standards,

June 2004, page 159.

Defining Risk

Risk can be defined in terms of

unexpected losses. Expected

losses are changes in values that

can be derived from information

currently anticipated, while

unexpected losses are potential

deviations from the expected

losses (or gains).

Unexpected losses arise, for

example, as a result of:

Unexpected fluctuations in

market values (e.g., share

prices, five-year euro swap

rate, five-year credit spread

for Brazil)

Unexpected credit rating

downgrades and a larger-than-

expected amount of loan

defaults (e.g., as a result of an

economic crisis)

An unexpectedly high number

of processing errors causing

especially serious damage (e.g.,

loan processing, payments)

By contrast, expected losses

could include:

Expected fluctuations in market

values (e.g., share prices due

to dividend payments;

movements in bond and option

prices due to changes in their

residual maturity)

Expected (average) number and

amount of loan defaults and

expected credit rating

downgrades (rating migration)

Expected (average) number of

processing errors causing

normal levels of damage

Market Risk Credit Risk OpRisk Other

Overall Economic CapitalOverall Risk!

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