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CAPITAL MANAGEMENT

Dr Philip Symes
Philip Symes, 2006

Agenda

I. II. III. IV. V.

Philip Symes, 2006

INTRODUCTION REASONS FOR CAPITAL MANAGEMENT RISK ANALYSIS CAPITAL MANAGEMENT MEASUREMENT FRAMEWORK

Introduction

Capital management is a big issue in banks and financial organisations. The topic covers a range of issues, but is mostly concerned with the level of risk. In order to manage the banks assets properly, the maximum amount of capital should be invested whilst not creating any adverse risk to the bank. This presentation Explains capital management Describes a measurement framework for risk assessment and capital management.

Philip Symes, 2006

Introduction
Capital management services:
BUSINESS STRATEGY Phase I RISK MANAGEMENT FRAMEWORK Phase II
Policies, Processes & Reporting Risk Organisation & People

RISK MEASUREMENT & MONITORING Phase III

Performance Capital Measurement Management & Valuation

SOLUTION SELECTION Phase IV

People

SOLUTION IMPLEMENTATION Phase V

Interfaces

Testing

Business Strategy

Risk Methods
Risk Profile Information Technology Current State Models Limit setting & monitoring
Technology Process

Training

Data Conversion

Philip Symes, 2006

RAROC, SVA Internal controls review Decision Support Survey of leading practices Develop risk strategy and framework Risk profiling

Risk and Capital Model design and development Methodology reviews Portfolio and scenario analysis Selection of risk factors and measures Capital Optimisation Design scenario analysis

Definition of business requirements Buy versus build analysis System selection Shortfall analysis of selected system and solution plan Infrastructure design

Interface with feeder systems Database integration Customisation for clients specific needs

Introduction
Drivers of capital management
Management Needs: Clarity of Roles Identifiable Standards Motivate Change Risk Awareness Real Time Monitoring Performance Measures Cost Efficiencies

Influencing Factors

External Pressures: BIS Capital Requirements Turnbull Requirements Market Events Stakeholder Performance Measures Competition

Education and Control Culture Identify and Assess Market, Credit, Operational & Strategic Risk Measurement of risks

Philip Symes, 2006

Effective Capital Management Framework

Optimise investment capital / Real options analysis

Risk adjusted performance measurement Gain efficiencies in business processes / organisation / resources Capital allocation

Capital Management
Market Pressures:

Need to meet developing regulatory requirements BIS, Fed, BAK Need to protect and maintain reputation and brand name of the group Potential to gain clear competitive advantage over other major financial institutions Need to demonstrate leading edge capital allocation capability to protect credit rating Need to demonstrate governance to external parties analysts / stakeholders

Philip Symes, 2006

Capital Management
Commercial Pressures:

Need to have enough capital buffer to satisfy policy holders Need to optimize the risk-return relationship Protect shareholder value Need to facilitate introduction of RAROC Improve pricing of products and increase control over the introduction of new products Budgetary pressures to reduce operational cost base

Philip Symes, 2006

Capital Management
Business Pressures:

Need to achieve a clear and consistent vision of capital allocation across the whole group Establish an capital allocation leadership position internally and externally Need to establish a robust platform to build future capital allocation initiatives Need to identify and prioritise critical capital allocation improvements Need to provide customised solutions for the different business areas

Philip Symes, 2006

Risk Analysis
Key components of a diversified company:
Capital Markets Retail Banking Asset Management Insurance

Key Risk Components

Philip Symes, 2006

Market Risk

Credit Risk

Operational Risk

Insurance Risk

Strategic Business Risk

Risk Adjusted Performance Measurement

Capital Allocation

Risk Management

Shareholder Value Added

Risk Analysis
Definition of key risk components

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Trading and Market risk Exposure of a institutions financial condition to adverse movements of market parameters (rates). The most developed area of risk management, although pressure from the regulators and continued high profile losses still mean that institutions are investing. Credit risk Risk that losses are incurs if a customer does not fulfill its financial obligations. This is the next major focus of regulatory attention and is heavily featured in Basel2 proposals. With the trend to consolidation and globalisation, firm-wide credit risk management becomes both harder and more important.

Philip Symes, 2006

Risk Analysis
Definition of key risk components

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Operational risk Exposure created by deficiencies of IT, processes and controls that may result in unexpected losses. This is another area of increased regulatory attention. There is also a clear drive for operational efficiency in all financial institutions. Insurance Risk Convergence of the Banking and Insurance markets, evidenced by several mergers and the emergence of ART techniques means that the integration of risk management across the two risk classes needs to be addressed rapidly.

Philip Symes, 2006

Capital Management
Capital allows an organisation to withstand volatility in its earnings stream and in the value of its assets and liabilities. Economic capital must be available to absorb large losses without adversely impacting the organisations ability to continue to meet its obligations. It should be available without management, operating, market driven or regulatory restrictions. Economic capital should cover losses arising from credit, market and operational risk to the extent that expected losses have not been included in the provision amounts. In an insurance context, capital is required to cover a combination of both catastrophic and non-catastrophic losses arising from claims and recoveries.

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Capital Management

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Provisions should cover expected losses and economic capital should cover the unexpected losses.
0.2

0.1

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0.0
Expected Loss Premiums Unexpected Loss Capital Perdition?

Capital Management
Risk adjusted performance measurement issues:

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Philip Symes, 2006

Return and Risk Adjusted Return may lead to different management decisions. Return must be sufficient to cover perceived risk. Return on Capital must exceed investors benchmark. Risk profile and hence required return will vary for each businesses. Specific approaches will need to be determined for each area. Source of risk and return must be matched to ensure meaningful results (e.g. same timing, business unit, etc...).

Capital Management

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Top-Down approach to Capital Modelling Volatility of earnings provides a high level (although historically based) indication of risk ... correlation factor * EAR gives diversified EAR Diversification factor: how much you saved

Earnings Volatility
Simple Transparent Fast to implement Common to all business units Risk-based capital allocation
Philip Symes, 2006

Example
Correlation EAR Diversification Diversified Factor Factor EAR Insurance Banking Investment 0.43 0.78 0.41 105 224 54 60 49 32 45 175 22

--------------------------------------------------------------------Total 383 141 242

Capital Management
Capital Modelling as a bottom up process:

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A granular approach to capital management determining the capital required by each risk type As each area has different performance/Risk indicators, the difficulty is to aggregate them. Insurance and banking will have different P/L profiles. Many constraints can be set that are more useful than Probability of complete loss. Eg: minimum of return expected, result relative to peers...

Philip Symes, 2006

Capital Management
Bottom-up approach to Capital Modelling
Group Capital Management
Market Risk Credit Risk Operational Risk Insurance Risk

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Value at Risk

Expected Default Frequency, Loss Given Default

Qualitative self Expected Claims assessment & Unexpected Quantitative Claims Causal Modelling

Volatility of Earnings

Philip Symes, 2006

Performance Measurement

Portfolio & Trading Limit Setting

Economic Buffering

Stakeholder Assurance

Capital Management
Top down and bottom up processes compared

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Top-Down: Quick Easy reconciliation with financial statements captures all risk drivers cannot decompose risk factors Bottom-up Not quick to implement Siloed by business units captures specific risks has well defined mathemetical basis

Philip Symes, 2006

Capital Management
Reconciliation of the two processes

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Each approach reflects a different perspective of the firm activity Each approach should give similar relative performance Mathematically the two approaches could be reconciled Practically figures can seldom be reconciled Approaches should be calibrated to identify any inconsistency

Philip Symes, 2006

Time Horizons
The impact of time horizon of measurement is significant:

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Philip Symes, 2006

The time horizon used to quantify capital will vary depending upon risk type and business unit. Shareholders will have an horizon of several years Time horizon will vary with Business Units Trading horizon might be limited to bonus payment Business unit horizon will be limited by reporting deadline An overall business process will have a longer horizon than processes in the dependent units Establishing a significant time horizon for capital allocation is not a trivial task

Measurement Framework

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Need to establish a measurement framework for capital allocation

Philip Symes, 2006

Easy if right accounting Evaluate total capital needed by the firm Quantify the Capital consumed by each business unit Set a Risk Adjusted Return target Hurdle rate expected by the market Investors expectations Time horizon important to set basis rate Measurement of actual returns by business units

Measurement Framework

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Need to establish a measurement framework for capital allocation (cont.)

Philip Symes, 2006

Evaluation of revenue distribution for products Evaluation of risk (normal vs catastrophic claims) Risk v Return Analysis Reporting of Performances must be consistent with the business Key point as explained before (slide above) Importance of expectation of all parties involved: customer/market, invertors, management Evaluation of real risk adjusted return of the firm Policy year as revenue and expenses decided in a year are attributed on the 2 following years 1 year should not be enough

Measurement Framework

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Probability distribution of a revenue item One way to evaluate the expected return of a product of the firm. Firm might find many others, but obtaining a distribution helps quantifying
25%

Probability in Band
20%

Fitted Distribution

15%
Philip Symes, 2006

Observed Distribution

Revenue Item Grouped in Bands

5%

10%

0% x <0 0<= x < 100<= x 200<= x 300<= x 400<= x 500<= x 600<= x 700<= x 800<= x 900<= x 1000<= 100 < 200 < 300 < 400 < 500 < 600 < 700 < 800 < 900 < 1000 x

Measurement Framework
Risk v. return optimising strategy Effective Capital allocation should lead to this efficient frontier. The framework should help to identify actions to take to approach the efficient frontier Economic Value = Discounted Value of Shareholder Funds and Dividends
900 Expected Value of Economic Value 800 700 600 500 400 300 200 100 0 0 50 100 150 200 250 300 350 Standard De viation of Econom ic Value

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Estimated Best Strategies

Results from different strategies

Philip Symes, 2006

Current Strategy

Measurement Framework
Capital is allocated by risk type and by business line key point Risk of business Expected return Then type of capital And amount Capital comes at a cost and its use should be justified by a suitably high RAV Analysis of all portfolios as a start of the loop (later) Economic capital allocation intervenes in estimation of RAROC Optimised Capital for existing portfolio should maximise Economic Value Added (EVA) => can be seen as operating profit after taxes minus cost of capital. Really investors measure.

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Measurement Framework

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Correlation & Diversification across Risk Types

Market Risk Credit Risk Operational Risk Insurance Risk Strategic Business Risk

Correlation & Diversification

within Risk Types

Business Line 1 Business Line 2 Business Line n

Philip Symes, 2006

D iv e r s ifie d C a p ita l
Capital Allocation

U n -d iv e r s if ie d C a p ita l
Performance Measurement

M a r g in a l C a p ita l

Measurement Framework

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RAROC
Portfolio RiskAdjusted NPV (RAV)

Portfolio optimisation loop

PORTFOLIO
(products, counterparties, methods, initiatives)
Operational Risk Insurance Risk Strategic Business Risk

Market Risk

Credit Risk

Philip Symes, 2006

Economic Capital Allocation

Cost of Capital

Optimise Capital / Portfolio

Measurement Framework

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Efficient capital management is essential when regulatory capital becomes a constraint If economic capital > regulatory captial: No capital tied up. If regulatory capital > economic capital: Capital immobilised > exposure, so need to reduce reg. capital by estimating risk adjusted reg. capital
Economic Capital Constraint Regulatory Capital Constraint
Exposure to be managed

Capital Required

Use Return on (Risk Adjusted) Economic Capital

Use Return on (Risk Adjusted) Regulatory Capital to reduce Regulatory Capital Exposure Regulatory Economic Capital Capital

Philip Symes, 2006

Regulatory Economic Capital Capital

Summary

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Philip Symes, 2006

Banks economic capital is finite and must be managed wisely to optimise returns. Analysis of risk should account for risk from different sources (market, credit, etc.) A measurement framework must be established for capital allocation. Capital can be modelled with a bottom-up or top-down approach. Capital should be allocated by risk type and business line. Time horizons are important for risk allocation.