Economic Capital andRAROCChapter23RiskManagementandFinanciallnstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Economic Capital and RAROC 1
Economic CapitalA bank's own assessment of the capital itrequires2RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Economic Capital ⚫ A bank’s own assessment of the capital it requires 2
ModelUsedforEconomicandCapital(SameasRegulatoryCapital)Figure 23.1, page 492ExpectedX% WorstLossCaseLossCapitalLossovertimehorizon05101520303540253RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Model Used for Economic and Capital (Same as Regulatory Capital) Figure 23.1, page 492 -0.2 0 0.2 0.4 0.6 0.8 1 1.2 0 5 1 0 1 5 2 0 2 5 3 0 3 5 4 0 Loss over time horizon Expected Loss X% Worst Case Loss Capital 3
Choice of Parameters● For a bank wishing to maintain a AA-rating, capital is chosen so that Xis about99.95% and time horizon is one yearThis is because statistics from ratingagencies show that an AA-rated companyshould have a probability of only about0.05% of defaulting in one year4RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Choice of Parameters ⚫ For a bank wishing to maintain a AArating, capital is chosen so that X is about 99.95% 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 about 0.05% of defaulting in one year 4
TheBaselIlRegulatoryEnvironmentt(Figure23.2,page493)TotalRiskNon-BusinessRiskBusinessRisk(regulatory capital):(noregulatorycapital)Credit RiskRisk from StrategicMarketRiskDecisionsReputationRiskOperationalRisk5RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 The Basel II Regulatory Environment (Figure 23.2, page 493) Total Risk Business Risk (no regulatory capital): Risk from Strategic Decisions Reputation Risk Non-Business Risk (regulatory capital): Credit Risk Market Risk Operational Risk 5
One-yearMarketRiskGains/LossDistribution (Figure23.3,page496)GainLoSSRiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull20126
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 One-year Market Risk Gains/Loss Distribution (Figure 23.3, page 496) 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 -6 -4 -2 0 2 4 6 Gain Loss 6
One-yearCreditRiskLossDistribution (Figure23.4, page 496)LoSSRiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull20127
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 One-year Credit Risk Loss Distribution (Figure 23.4, page 496) 0 0.1 0.2 0.3 0.4 0.5 0.6 0 5 10 15 Loss 20 7
OneYearOperationalRiskLossDistribution (Figure23.5,page 496)LoSSRiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull20128
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 One Year Operational Risk Loss Distribution (Figure 23.5, page 496) Loss 8
Characteristics ofDistributions(Table 23.1, page 497)SecondThirdFourthMomentMomentMoment(Variance)(Skewness)(Kurtosis)ZeroLowHighMarket RiskCredit RiskModerateModerateModerateLowHighHighOperationalRisk9RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Characteristics of Distributions (Table 23.1, page 497) Second Moment (Variance) Third Moment (Skewness) Fourth Moment (Kurtosis) Market Risk High Zero Low Credit Risk Moderate Moderate Moderate Operational Risk Low High High 9
Importance of Risks (page 497)Type of BusinessMost ImportantRiskCommercialCredit RiskBankingInvestmentMarket Risk andCredit RiskBanking & TradingAsset ManagementOperational Risk10RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Importance of Risks (page 497) Type of Business Most Important Risk Commercial Banking Credit Risk Investment Banking & Trading Market Risk and Credit Risk Asset Management Operational Risk 10