Hull RMFICh 16

Economic Capital and
RAROC
Risk Management and Financial Institutions, Chapter 16, Copyright John C. Hull 2006
16.1
Economic Capital
Banks own assessment of the capital it

requires
16.2
Model Used for Economic and Capital

(Same as Regulatory Capital)
Figure 16.1, page 367
Expected
Loss
1.2
X% Worst
Case Loss
Capital
0.8
0.6
0.4
Loss over
time horizon
0.2
0
0
10
15
20
25
30
35
40
-0.2
16.3
Choice of Parameters
For a bank wishing to maintain a AArating, capital is chosen so that X =

99.97% and time horizon is one year
This is because statistics from rating
agencies show that an AA-rated company
should have a probability of only 0.03% of
defaulting in one year
16.4
The Basel II Regulatory

Environment (Figure 16.2, page 367)
Total Risk
Non-Business Risk
(regulatory capital):
Business Risk
(no regulatory capital):
Credit Risk
Market Risk
Operational Risk
Risk from Strategic

Decisions
Reputation Risk
16.5
One-year Market Risk Gains/Loss

Distribution (Figure 16.3, page 371)
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
-6 Gain-4
-2
4 Loss 6
16.6
One-year Credit Risk Loss

0.6
0.5
0.4
0.3
0.2
0.1
0
0
10
15
Loss
20
16.7
One Year Operational Risk Loss

0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
10
Loss15
16.8
Characteristics of Distributions
(Table 16.1, page 371)
Second
Moment
(Variance)
Credit Risk
Third
Moment
(Skewness)
Fourth
Moment
(Kurtosis)
Moderate Moderate Moderate
Market Risk High
Zero
Low
Operational
Risk
High
High
Low
16.9
Importance of Risks (page 372)

Type of Business
Commercial
Banking
Investment
Banking & Trading
Most Important
Risk
Credit Risk
Market Risk and
Credit Risk
Asset Management Operational Risk
16.10
European Growth Trust (Example of

Operational Risk in Asset Management)
See Business Snapshot 16.1
No more than 10% of EGT could be

invested in unlisted securities
Peter Young the fund manager violated
this rule
The cost to Deutsche Bank was about
$200 million
16.11
Interactions of Risks
Credit
Risk
LGD and PD
depend on
market value
Market
Risk
Operational risks can be

contingent on market
moves or credit events
Operational
Risk
16.12
Integrated Risk Management

Typically a bank calculates economic
capital for different types of risk and
different units
It is then faced with the problem of
aggregating the risks
16.13
Combining the Distributions
Assume perfect correlation: overstates

capital by about about 40%
Assume distributions are normal for the
purposes of aggregation: understates
capital by about 40%
Hybrid approach: E E E
seems to work reasonable well
n
total
i 1 j 1
ij
16.14
Example: Economic Capital

Estimates (Table 16.2, page 376)
Market Risk
Business
Unit 1
30
Business
Unit 2
40
Credit Risk
70
80
Operational Risk
30
90
16.15
Correlations
Market and credit risk within the same

business unit: 0.5
Market and operational risk or credit and
operational risk within the same business
unit: 0.2
Market risks across business units: 0.4
Credit risk across business units: 0.6
Operational risk across business units: 0.0
16.16
Total Economic Capital
Business Unit 1: 100.0

Business Unit 2: 153.7
Whole bank: 203.2
Diversification benefit is 253.7 203.2 = 50.5
How should this be allocated to the business
units?
Equivalently how should the total economic
capital of 203.2 be allocated?
16.17
Alternatives
Allocate economic capital in proportion to

the stand alone economic capitals
Allocate economic capital in proportion to
marginal contribution of business units to
total economic capital
Set economic capital for business unit i
equal to x xE where xi is the size of
business unit i
i
16.18
Deutsche Bank Economic Capital

(millions of Euros) Table 16.4, page 379
Credit Risk
Market Risk
Diversification:
Credit and Mkt Risk
Operational Risk
Business Risk
Total
Regulatory Capital
Actual Capital
5,971
5,476
-870
2,243
381
13,201
17,300
28,600
16.19
RAROC (page 379)
RAROC is the return on economic capital for a

business unit
The denominator is the economic capital
allocated to the business unit
The numerator is the expected profit. This can
be before or after tax and can include a interest
at the risk-free rate on the economic capital
It is sometimes also referred to as RORAC
16.20
Example 16.5 (page 380)
When lending in a certain region of the

world an AA-rated bank estimates its
average losses from defaults as 1% of
outstanding loans per year
The 99.97% worst case loss is 5% of
outstanding loans
Economic capital per $100 of loans is
therefore $4
16.21
Example continued
The banks spread between cost of funds and interest

charged is 2.5% and administrative costs are 0.7%
.0.025 100 0.01 100 0.007 100

RAROC
20%
4.0
If interest on the economic capital is included and the
risk free rate is 2% this becomes
0.88
22%
4.0
16.22
Ex-ante vs Ex-post
RAROC was originally suggested as a tool to be

used on an ex-ante basis. This means that we
have to forecast the expected loss
It is then used as a tool to allocate capital to the
most profitable parts of the business
It is also sometimes used on an ex-post basis for
performance evaluation. Realized loss then
replaces expected loss
16.23

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Economic Capital and

Banks own assessment of the capital it

Model Used for Economic and Capital

For a bank wishing to maintain a AArating, capital is chosen so that X =

The Basel II Regulatory

Risk from Strategic

One-year Market Risk Gains/Loss

One-year Credit Risk Loss

One Year Operational Risk Loss

Moderate Moderate Moderate

Market Risk High

Importance of Risks (page 372)

Asset Management Operational Risk

European Growth Trust (Example of

No more than 10% of EGT could be

Operational risks can be

Integrated Risk Management

Combining the Distributions

Assume perfect correlation: overstates

Example: Economic Capital

Market and credit risk within the same

Total Economic Capital

Business Unit 1: 100.0

Allocate economic capital in proportion to

Deutsche Bank Economic Capital

RAROC (page 379)

RAROC is the return on economic capital for a

Example 16.5 (page 380)

When lending in a certain region of the

The banks spread between cost of funds and interest

.0.025 100 0.01 100 0.007 100

RAROC was originally suggested as a tool to be

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