Capital Management

 

CAPITAL MANAGEMENT                                                                                                    


Capital Management is a core disciplin of banks. Hereby, Regulatory Capital as a must-have requirement for doing business needs to be distinguished from Economic Capital which is used as both, a common "currency of risk" across the bank as well as an important steering quantity in portfolio management and pricing frameworks.


Regulatory Capital currently follows the guidelines of the Basel 2 Accord plus national regulation specialties. For instance, the capital approach of Basel 2 for a standard loan is easily explained, namely: Regulatory Capital is defined as risk-weighted assets RWA multiplied with the regulatory solvability coefficient of 8% (or higher). Risk-weighted assets, in short: RWA, are the product of

  1. • the credit exposure (EAD which stands for "exposure at default"),

  2. • the expected loss rate of the loan (LGD which stands for "loss given default"),

  3. • a capital factor K(PD) depending on the default probability (PD) of the loan, and

  4. • a maturity adjustment factor determined by the default probability of the loan and its maturity.







The capital factor K(PD) is based on the quantile function (with a confidence level of 99.9%) of a distribution well-know to credit risk modelers (the so-called Vasicek distribution). Different loan types imply different capital factors.


Note that in the RWA formula the factor 12.5 = 1 / 8% reflects the regulatory solvability coefficient. Some national regulations tend to ask for higher solvability as a consequence of the recent crisis. For credit risk related regulatory capital, different loan types need different capital factors.


In contrast, Economic Capital is typically calculated based on internal proprietary models of banks based on one out of a handful of common industry approaches for modeling credit, market, operational and business risks. A graphical illustration can be found here.


Capital Management is the basis for an efficient use of Economic and Regulatory Capital for the benefit of stakeholders. To mention some examples, capital management includes

  1. • Avoidance of "capital wastage" with respect to both - economic as well as regulatory capital,

  2. • Allocation of available capital to businessess in the bank (so-called capital allocation),

  3. • Pricing of capital and internal capital clearing mechanisms,

  4. • Capital relief measures, risk transfer, etc.