7 - Economic capital allocation: Practical applications and theoretical background

Abstract

This chapter discusses the practical applications of economic capital allocation by means of real-life examples. As banks with experience in economic capital allocation appreciate, funding for extreme events is not the same as allocating capital for expected losses. Exposure connected to expected and unexpected losses varies tremendously by instrument. Derivatives add a great deal to tail risk. In contrast, American banks emphasized the point that with credit card receivables nearly everything is expected risk. Because no senior executives or business units wish to be considered risk-prone, a major challenge is that of calculating risk appetite by instrument, product line, and business unit. Many business unit executives and product-line managers tend to shy away from high capital allocation because of the fact that if they need substantial capital then they will be expected to present big profits or they may be considered bad managers. Whether economic capital allocation is top down or bottom up, there should always be a general management account (GMA) at headquarters. The mission of GMA serves well the principle which states that a credit institution should manage its assets in a way that other people are willing to buy them. This concept goes beyond value-based management because it weights-in the risks assumed by business unit and channel all the way to solvency.