Economic Capital Requirements Research Articles

Investigation and Modelling of Economic Systematic Risk and Capital Requirement: A Monte Carlo Simulation

This paper tests the ability of the regulatory capital requirement to cover credit losses at default, as carried out by the economic (optimal) capital requirement in Tunisian banks. The common factor in borrowers that leads to a credit default is systematic risk. However, the sensitivity to these factors differs between borrowers. To this end, we derived two kinds of sensitivity to systematic risk: the first is recognised by the Basel Committee; the second is derived from an economic approach. Hence, we can observe the impact of sensitivity to systematic risk on capital requirements. Empirically, we studied a sample of 100 individual borrowers from a Tunisian deposit bank that had credit in January 2020. We estimated the default probability for each borrower and then simulated their systematic risk sensitivity using the Monte Carlo approach, and compared them with the regulatory risk sensitivity. Then, we tested their effects on the economic and regulatory capital requirements. The results indicate that regulatory capital overestimates economic capital. This is due to the overestimation of borrowers’ contagion in terms of default risk, as shown by the superiority of their regulatory sensitivity systematic risk compared to the simulated risk. This leads banks to devote more capital than is really necessary to reach the regulatory standard. Hence, there was an increase in capital costs and the possibility of an arbitrage opportunity.

Impacts of Solvency II Regulations on the Insurance Companies and their Operations

To run a market smoothly, regulations are very important. These regulations worked as set of parameters for all business operators, managers and their key stakeholders of a specific domain to work under certain rules so that every business has equal opportunity to earn and expand their operations. In Europe since mid of 18th century several legislations were introduced to regulate the market to protect the rights of investors, business and their stakeholders and also to create a free and fair market for all. Insurance companies and their managers were facing a problem with dissymmetry of information which means that they either they do not share important information to each other or either the access to the information was a way costly for them. There was a need of monitoring the economic activities and setting certain requirements for licensing. Regulations, ethics and rules were being introduced since 1800s. after the mid of 20th century, a series of regulations were introduced to regulate the insurance market in Europe according to one market policy and from this series the latest regulations implemented in 2016 are termed Solvency II regulations. Solvency II regulations introduced new risk based economic capital requirements that

Eurozone Sovereign Default Risk and Capital: A Bayesian Approach

Using a Bayesian generalized linear mixed model (GLMM), we analyze Eurozone sovereign real-world default probabilities and correlations, and compare regulatory and economic capital requirements. The approach combines prior information and sparse sovereign historical default data. One main finding is that capital under the Basel internal ratings based approach (IRBA) is higher than under the standardized approach (SA) by a factor of 2.06 to 8.86, depending on the method for estimating the probability of default. This divergence is driven mainly by zero capital charges for highly rated securities under the SA. Furthermore, under the Bayesian model, Basel IRBA capital is roughly equivalent to economic capital using the expected shortfall at a 99% confidence level. The results suggest that the zero risk weights under the SA are not consistent with economic risk and offer opportunities for regulatory arbitrage.

Carbon neutrality, bank lending, and credit risk: Evidence from the Eurozone

The development of a green financial intermediation channel is imperative to achieve zero-carbon economies. In this study, we assess the impact of carbon-neutral lending on the credit risk in the Eurozone. We employ quarterly data for a sample of 344 lending institutions of 19 member states spanning over ten years from 2011 to 2020. Using two specific credit risk measures, the findings show that the exposure to carbon-neutral lending is negatively related to the default risk. The results remain consistent for the various size sorts, depicting that regardless of the bank size, the impact of green financing on the credit risk is the same. We attribute the credit risk reduction to the lower volatility of the borrowers' earnings and cash flows emanating from their sustainable business model. As a consequence of lower credit risk, financial institutions can benefit from lower loan loss provisions and economic capital requirements. This incentive is vital to increase the carbon neutral credit and contribute towards pro-environmental goals.

Tweedie double GLM loss triangles with dependence within and across business lines

We propose a stochastic model allowing property and casualty insurers with multiple business lines to measure their liabilities for incurred claims risk and calculate associated capital requirements. Our model includes many desirable features which enable reproducing empirical properties of loss ratio dynamics. For instance, our model integrates a double generalized linear model relying on accident semester and development lag effects to represent both the mean and dispersion of loss ratio distributions, an autocorrelation structure between loss ratios of the various development lags, and a hierarchical copula model driving the dependence across the various business lines. The model allows for a joint simulation of loss triangles and the quantification of the overall portfolio risk through risk measures. Consequently, a diversification benefit associated to the economic capital requirements can be measured, in accordance with IFRS 17 standards which allow for the recognition of such benefit. The allocation of capital across business lines based on the Euler allocation principle is then illustrated. The implementation of our model is performed by estimating its parameters based on a car insurance data obtained from the General Insurance Statistical Agency (GISA), and by conducting numerical simulations whose results are then presented.

Macroeconomic shocks and credit risk stress testing the Iranian banking sector

PurposeThe Iranian banking industry has been greatly affected by dramatic changes in macroeconomic conditions over the past several decades owing to volatile oil revenues, changing fiscal and monetary policies, and the imposition of US sanctions. The main objective of this paper is to estimate potential credit losses in the Iranian banking sector due to macroeconomic shocks and assess the minimum economic capital requirements under the baseline and distressed scenarios. The paper also contrasts the applications of linear and nonlinear models in estimating the impacts of macroeconomic shocks on financial institutions.Design/methodology/approachThe paper uses a multistage approach to derive the portfolio loss distribution for banks. In the first step, the dynamic relationship between the selected macroeconomic variables are estimated using a VAR model to generate the stress scenarios. In the second step, the default probabilities are estimated using a quantile regression model and the results are compared with those of the conventional linear models. Finally, the default probabilities are simulated for a one-year time horizon using Monte-Carlo method and the portfolio loss distribution is calculated for hypothetical portfolios. The expected loss includes the loss given default for loans drawn randomly and uniformly distributed and exposed at default values when loans are assigned a fixed value.FindingsThe results indicate that the loss distributions under all scenarios are skewed to the right, with the linear model results being very similar to those of quantile at the 50% quantile, but very unlike those at the 10% and 90% quantiles. Specifically, the quantile model for the 90% (10%) quantile generates estimates of minimum economic capital requirement that are considerably higher (lower) than those using the linear model.Research limitations/implicationsThe study has focused on credit risk because of lack of data on other types of risk at individual bank level. The future studies can estimate the aggregate economic capital using a risk aggregation approach and a panel data (not presently available), which could further improve the accuracy of the estimates.Practical implicationsThe fiscal and monetary authorities in developing countries, specially oil-exporting countries, can follow the risk assessment approach to assess the health of their banking system and adapt policies to mitigate the impacts of large macroeconomic shocks on their financial markets.Originality/valueThis is the first paper estimating the portfolio loss distribution for the Iranian banks under turbulent macroeconomic conditions using linear and nonlinear models. The case study can be applied to other developing and emerging countries, particularly those highly dependent on natural resources, prone to extreme macroeconomic shocks.

IFRS 9 compliant economic adjustment of expected credit loss modeling

This paper presents an International Financial Reporting Standard 9 (IFRS 9) compliant solution related to expected credit loss modeling. Commonly, credit default swap (CDS) spreads are considered as market indicators of future debt performance. However, we demonstrate empirically that nondefault risks explain a relevant part of the CDS spread, and we assess the average weight-of-default component for each point in the CDS spread term structure. Thus, to be used for probability of default estimations, CDS spreads must be adjusted for the nondefault component to guarantee the neutral character of expected credit loss estimations, as required by IFRS 9. Our study introduces an innovative methodology for extracting the pure default component and probability of default calibration. To enable economic adjustment of probabilities of default we analyze the relationship between a long-run average of the across-the-sample mean CDS spread of the homogeneous cohort of issuers and the spread implied by the long-run average of the observed default rates. Our easy-to-implement solution is applied to a sample of investment-grade and high-yield corporate debt issuers. We exploit differences in the economic performance of North American and eurozone obligors. The proposed framework allows us to understand complex interactions between the forward-looking impairment provisions and economic capital requirements in relation to credit losses.

The Impact of Ownership Risk in True Sale-Based Financing on Profit Charges: A Structural Equation Modelling (SEM) Approach

The fundamental principle of true sale is based on the ownership state of the subject matter of sale where the selling party must own the asset legally and keep full ownership of the goods before making the sale. In the riba-free system, the Islamic bank assumes a role of a trading entity. It undertakes a trading position and exposes itself to business risk as the asset is booked on its balance sheet. It follows that the profit rate it charges the customer will reflect an additional risk-premium to account for the business risk exposure. Due to business risk exposure, this study introduces the financial infrastructural constraints on the use of true sale-based Islamic financing namely 1) economic capital requirement for the on-balance sheet holding of tradable assets and 2) the tax charges by the fiscal authority on the purchase of tradable assets by the bank. Thus, based on this premise, the objective of this study was formulated to empirically investigate the impact of these constructs (cost of fund, overhead, default risk, capital charges, tax burden and profit rate) on profit rate of true sale-based financing. A Survey questionnaire and a semi structured interview were the tools used for data collection. The analysis was done by using Structural Equation Modelling (SEM) technique and the findings revealed that all independent variables except for cost of fund, have positive and significant impacts towards profit rate charged. Given the findings of this study, it is recommended that the true sale-based Islamic financing is to be funded by investment fund rather than deposit fund. Hence, the additional capital and tax charges will be absorbed by the investors. From this study, we hope that future research could be expanded further by investigating cross border Islamic banking practices in terms of the pricing of true sale model and closer comparison can be made between Malaysian Islamic banks and Foreign Islamic banks.

Credit Risk Analysis Using Quantum Computers

We present and analyze a quantum algorithm to estimate credit risk more efficiently than Monte Carlo simulations can do on classical computers. More precisely, we estimate the economic capital requirement, i.e. the difference between the Value at Risk and the expected value of a given loss distribution. The economic capital requirement is an important risk metric because it summarizes the amount of capital required to remain solvent at a given confidence level. We implement this problem for a realistic loss distribution and analyze its scaling to a realistic problem size. In particular, we provide estimates of the total number of required qubits, the expected circuit depth, and how this translates into an expected runtime under reasonable assumptions on future fault-tolerant quantum hardware.

Strategic risk, banks, and Basel III: estimating economic capital requirements

PurposeBasel III regulations require banks to protect themselves against strategic risk. This paper aims to provide a comprehensive and measurable definition of this risk and proposes a framework to estimate economic capital requirements.Design/methodology/approachThe paper studies the literature and solicits expert opinion in formulating a comprehensive and measurable definition of strategic risk. The paper postulates that the economic capital for a bank’s strategic risk should be estimated using the cost of equity as the profitability threshold, rather than zero and develops a simulation-based framework to estimate economic capital.FindingsThe framework closely matches the actual economic capital outlay for strategic risk from our case study of ABN AMRO. It is shown that a bank’s strategic growth plans can fall into one of two scenarios based on risk-return characteristics. In one scenario, the required economic capital outlay will increase, and decrease in the other.Practical implicationsThis framework is generalizable and makes use of widely accepted and used practices in banks, making it readily implementable in practice. It does not introduce errors resulting from model selection, parameterizations or complex calculations.Social implicationsSociety would be worse off in the absence of banking and lending services. Banks need to take risks to grow and stay competitive. The framework facilitates better strategic risk management, protecting banks from collapse and reducing the need for taxpayer-funded bailouts.Originality/valueThe paper provides a measurable and practitioner-verified definition of strategic risk and proposes a simple framework to estimate economic capital requirements, a crucial topic, given the threats and increased levels of strategic risk facing banks.

An Assessment of the Market Risk Solvency Capital Requirement Simplifications for Insurance Undertakings

The Solvency II regulatory framework has been implemented as of January 1st, 2016 and among other things it introduced economic risk-based capital requirements across all EU Member States for the first time, applicable for insurance and reinsurance undertakings. Similar to Basel II whose scope is banks, the Solvency II directive provides a new regime based on three pillars for insurers and reinsurers: 1) pillar 1: harmonized valuation and risk based capital requirements, 2) pillar 2: harmonized governance and risk management requirements and 3) pillar 3: harmonized supervisory reporting and public disclosure. The Solvency Capital Requirement (SCR) should correspond to the Value-at-Risk of the basic own funds of an insurance or reinsurance undertaking subject to a confidence level of 99.5% over a one-year period. The Solvency II directive provides a range of methods to calculate the SCR. This allows insurance or reinsurance undertakings to choose a method that is proportionate to the nature, scale and complexity of the risk that is measured. In order to calculate the SCR, an insurance undertaking can use a fully internal model, the standard formula and a partial internal model, the standard formula with undertaking-specific parameters, the standard formula as it is or a simplification. When introducing a simplification, the SCR estimate could deviate from the calculation without the simplification. A simplification could lead in important/crucial information missing from the SCR calculation. In some occasions the SCR is overestimated and in some others it is underestimated. It is therefore of interest to find the range of this deviation, potential bounds—if any and the effect it can have on the required capital. In this paper we attempt to measure this deviation for simplifications pertaining to the interest rate risk for insurance companies.

Capital at Risk (Preliminary Version)

This paper introduces a new risk assessment technique called Capital at Risk (CaR) that overcomes the inaccuracies of the current risk measures and assists banks and other financial institutions in the evaluation of sound capital requirements. The procedure is non-parametric and non-quantile based and it is implemented through the use of historical data. The method comprises the following steps: i. Variance Modeling, ii. Risk aversion filtering, iii. Historical learning and model correction, iv. CaR forecasting. CaR is defined as the economic capital required by a financial institution to cover market risk losses relative to traded assets on a daily basis. It does not represent the highest potential loss nor an average. Although it is not definable as risk measure, CaR can be compared to Value at Risk (VaR) and Expected Shortfall (ES) in the evaluation of the economic capital requirements. The empirical results show that CaR generates less exceptions than 99%-Value at Risk and 97.5%-Expected Shortfall and that the exceptions produced by the risk measures are of greater magnitude. CaR also proves to be more sensitive to the changes in sign and magnitude of the P&L, reducing the potential for inflated reserves.

Rethinking economic capital management through the integrated derivative-based treatment of interest rate and credit risk

This research revisits the economic capital management regarding banking books of financial institutions exposed to the emerging market sovereign debt. We develop a derivative-based integrated approach to quantify economic capital requirements for considered jointly interest rate and credit risk. Our framework represents a major contribution to the empirical aspects of capital management. The proposed innovative modeling allows applying standard historic value-at-risk techniques developed for stand-alone risk factors to evaluate aggregate impacts of several risks. We use the time-series of credit default swap spreads and interest rate swap rates as proxy measures for credit risk and interest rate risk, respectively. An elasticity of interest rate risk and credit risk, considered a function of the business cycle phases, maturity of instruments, creditworthiness, and other macroeconomic parameters, is gauged by means of numerical modeling. Our contribution to the new economic thinking regarding the interest rate risk and credit rate risk management consists in their integrated treatment as the dynamics of interest rate and credit spreads is found to demonstrate the features of automatic stabilizers of each other. This research sheds light on how financial institutions may address hedge strategies against downside risks. It is of special importance for emerging markets heavily dependent on foreign capital as it potentially allows emerging market banks to improve risk management practices in terms of capital adequacy and Basel III rules. From the regulatory perspective, by taking into account inter-risk diversification effects it allows enhancing financial stability through jointly optimizing Pillar 1 and Pillar 2 economic capital.

Strategic Risk, Banks, and Basel III: Estimating Economic Capital Requirements

Purpose: Basel III regulations require banks to protect themselves against strategic risk. This paper provides a comprehensive and measurable definition of this risk and proposes a framework to estimate economic capital requirements. Design/methodology/approach: The paper studies the literature and solicits expert opinion in formulating a comprehensive and measur- able definition of strategic risk. The paper postulates that the economic capital for a bank’s strategic risk should be estimated using the cost of equity as the profitability threshold, rather than zero and develops a simulation-based framework to estimate economic capital. Findings: The framework closely matches the actual economic capital outlay for strategic risk from our case study of ABN AMRO. We show that a bank’s strategic growth plans can fall into one of two scenarios based on risk-return characteristics. In one scenario, the required economic capital outlay will increase, and decrease in the other. Practical implications: Our framework is generalizable and makes use of widely accepted and used practices in banks, making it readily implementable in practice. It does not introduce errors resulting from model selection, parameterizations, or complex calculations. Societal implications: Society would be worse off in the absence of banking and lending services. Banks need to take risks to grow and stay competitive. The framework facilitates better strategic risk management, protecting banks from collapse, and reducing the need for taxpayer-funded bailouts. Originality/value: The paper provides a measurable and practitioner-verified definition of strategic risk, and proposes a simple framework to estimate economic capital requirements, a crucial topic given the threats and increased levels of strategic risk facing banks.

INTERNATIONAL STANDARDS OF BANKING CAPITAL: ADAPTATION IN UKRAINE

The peculiarities of the state supervision of the Ukrainian banks and the regulation of their activities are re-searched. The state of the Ukrainian banking system at the present stage is analyzed, and the factors of influence on it are given. It is shown that common problem is lack of capitalization of Ukrainian banks, which led to the insolvency of a large number of them, the outflow of deposits, the growth of distrust to the banking system from the side of depositors and investors. In order to increase the efficiency of banking supervision and regulation some recommendations on adaptation the formation of bank capital to international standards of Basel III are offered, the advantages and disadvantages of the transition to international standards are shown. The study was conducted on the basis of data from a representative sample of the annual financial statements of the Ukrainian banks by the method of cluster analysis, k-means, on the basis of indicators of adequacy of regulatory capital H2 averaged by annual data. As a result of the analysis three groups of banks are selected in accordance with the level of riskiness approaches to capital formation: low-risk approach, moderate and high-risk ones. The division of banks into groups was carried out on the basis of analysis of variance, the calculations were made in the Statistica application. It is proposed to use additional analytical factors characterizing the formation of capital by banks, – a margin of safety of the capital base (the difference between the available sources of stable funding and needs for stable funding) and capital risk of systemically important banks (probability of failure by the bank regulatory capital adequacy). The establishment of minimum requirements for the formation of banks of systemic importance of the buffer was grounded on the basis of probability of failure of economic capital requirements and approaches to the formation of bank capital, which will lead, in practice, to effective management of the system and the individual capital of banking institutions risk. These proposals take into account the specifics of the national system of accounting and financial reporting of banks and formalized appropriate calculation algorithms.

Coordination of hydro units with wind power generation based on RAROC

Generating companies (GENCOs) with wind farms always suffer from the variations of wind power and energy prices. The coordination of wind power with hydro units is an effective way for GENCOs to enhance the ability of wind power dispatch, increase profit, and reduce risk. However, GENCOs still need to prepare a certain amount of economic capital to cover the possible losses and keep them operating even in a worst-case scenario. In this paper, bidding strategies' value at risk is adopted to determine the economic capital requirement, and the risk adjusted return on capital (RAROC) which represents the return of economic capital is introduced. Then, this paper proposes a coordination bidding strategy for wind farms and hydro stations in a GENCO based on RAROC optimization. RAROC can measure the performance of risk management and estimate the tradeoff between profit and risk. Compared to the risk-neutral strategies, the proposed method prevents the GENCO from huge losses by risk management. Compared to the traditional risk-averse strategies, the proposed method does not need to quantify the GENCO's risk aversion and it is helpful for economic capital determination. Numerical example illustrates the proposed bidding strategy, as well as the comparison analysis and sensitivity analysis.

Risk exposure mitigation: Approaches and recognised instruments (7)

The risk management function development in banks, along with the development of tools that banks can use throughout this process, has had the strong support in international standards, not only in the recommended approaches for calculating economic capital requirements, but also in the qualitatively new treatment of risk exposure mitigation instruments (Basel Accord II). The array of eligible instruments for exposure mitigation under the recommended approaches for their treatment becomes the essential element of economic capital requirements calculation, both in relation to certain types of risk, and in relation to aggregate exposure.

Risk exposure mitigation: Approaches and recognised instruments (9)

The risk management function development in banks, along with the development of tools that banks can use throughout this process, has had the strong support in international standards, not only in the recommended approaches for calculating economic capital requirements, but also in the qualitatively new treatment of risk exposure mitigation instruments (Basel Accord II). The array of eligible instruments for exposure mitigation under the recommended approaches for their treatment becomes the essential element of economic capital requirements calculation, both in relation to certain types of risk, and in relation to aggregate exposure.

Risk exposure mitigation: Approaches and recognised instruments (8)

The risk management function development in banks, along with the development of tools that banks can use throughout this process, has had the strong support in international standards, not only in the recommended approaches for calculating economic capital requirements, but also in the qualitatively new treatment of risk exposure mitigation instruments (Basel Accord II). The array of eligible instruments for exposure mitigation under the recommended approaches for their treatment becomes the essential element of economic capital requirements calculation, both in relation to certain types of risk, and in relation to aggregate exposure.

Role of the Pension Protection Fund in financial risk management of UK defined benefit pension sector: a multi-period economic capital study

AbstractWith the advent of formal regulatory requirements for rigorous risk-based, or economic, capital quantification for the financial risk management of banking and insurance sectors, regulators and policy-makers are turning their attention to the pension sector, the other integral player in the financial markets. In this paper, we analyse the impact of applying economic capital techniques to defined benefit pension schemes in the United Kingdom. We propose two alternative economic capital quantification approaches, first, for individual defined benefit pension schemes on a stand-alone basis and then for the pension sector as a whole by quantifying economic capital of the UK’s Pension Protection Fund, which takes over eligible schemes with deficit, in the event of sponsor insolvency. We find that economic capital requirements for individual schemes are significantly high. However, we show that sharing risks through the Pension Protection Fund reduces the aggregate economic capital requirement of the entire sector.