大浩浩的笔记课堂——FRM考试学习笔记119

Topic 48 

Range of Practices and Issues in Economic Capital Framework

1.Executive summary:

⑴use of economic capital and governance

⑵risk measures

⑶risk aggregation

⑷validation

⑸dependency modeling in credit risk

⑹counterparty modelling in credit risk

⑺interest rate risk in the banking book

⑻BIS recommendations

2.Use of economic capital and governance:

⑴definition of economic capital:

Economic capital is often parameterized as an amount of capital that a bank needs to absorb unexpected losses because expected losses are accounted for in the pricing of a bank´sproducts and loan loss provisioning.

⑵business-level use:

①credit portfolio management:

A.purpose:

It is to protect against risk deterioration.

B.measurement:

Economic capital is a measurement of the level of concentration.

②risk-based pricing:

A.purpose:

It is to maximize the bank´sprofitability.

B.example:

price=the cost of funding+the expected loss+allocated economic capital+extra-return required

③customer and product profitability analysis,customer segmentation and portfolio optimization:

It is to determine unprofitable or only slightly profitable customers.

④management incentives:

It is to motivate managers to participate in the technique aspects of the economic capital allocation process.

⑶enterprise-wide or group-level use:

①relative performance measurement such as RAROC and SVA

②capital budgeting,strategic planning,target setting and internal reporting

③acquisition/divestiture analysis

④external communication

⑤capital adequacy assessment

⑷governance(monthly or quarterly):

Best practices for the governance of an economic capital framework cover:

①senior management commitment involvement and experience in the economic capital process

②the business unit involved in the economic capital process and its level of knowledge

③the timing or frequency of economic capital measurements and disclosure

④polices,procedures and approvals relating to economic capital model development,validation,on-going maintenance and ownership

⑸Key concerns related to governance and the application of economic capital measures involve:

①senior management commitment to the economic capital process

②role of stress testing

③standard for absolute and relative measures of risk:

critical issues:

A.comprehensive capture of risks

B.diversification assumptions

C.assumptions about management actions:

a/ actions that increase capital supply

b/ actions that reduce capital demand

④Economic capital should not be the sole determinant of required 

capital.(look to peers)

⑤definition of available capital

⑥transparency and meaningfulness of economic capital measures

3.Risk measures:

⑴describable characteristics of risk measures:

①intuitive

②stable

③easy to compute

④easy to understand

⑤coherent(monotonicity,positive homogeneity,translation invariance,subadditivity)

⑥simple and meaningful risk decomposition

⑵the properties of a coherent risk measures:

①monotonicity

②subadditivity

③positive homogeneity

④translation invariance

⑶types of risk measures:

·特别注意！

·The factors causing the VaR variability:

*lack of uniformity in the use of confidence intervals and time horizons

*length of the time series

*ways of estimating moments

*mapping techniques

*delay factors

*number of simulations

·特别注意！

·A multitude of challenges exist within the economic capital framework.

⑷calculation of risk measures:

①confidence level

②time horizon:

A.market risk→short time horizon(days or weeks)

B.credit risk and operational risk→one-year time horizon(or longer)

③aggregation or decomposition

⑸supervisory concerns relating to risk measures

4.Risk aggregation:

⑴aggregation framework:

①the 2 dimensions:

A.the economic nature of the risk:

market risk,credit risk,operational risk

B.the organizational structure of the bank:

along business lines or legal entities

②typical framework classifies risks:

A.market risk:

Portfolio value changes due to changes in rates and prices such as IRRBB,stem from-repricing risk,yield curve risk,basis risk.

B.credit risk:

Portfolio value changes due to shifts in the likelihood that an obligor may fail to deliver cash flows.

C.operational risk:

The risk of loss associated with human or system failures,fraud,natural disaster and litigation.

D.business risk:

The risk to the firm´sfuture earnings,dividend distribution and equity price.

③range of practices in the choice of risk types

⑵aggregation methodologies:

①the unit of account:

A.risk metric

B.confidence level:

e.g.long-tailed risk distributions→using higher confidence levels

C.time horizon:

Using a common(usually 1 year) horizon 

②inter-risk diversification

③typically used aggregation methodologies:

A.summation:

a/ definition:

Adding together the individual capital components.

b/ advantages:

△simplicity

△considered to be conservative

c/ disadvantages:

△Do not discriminate across risk types.

△Impose equal weighting assumption.

△Do not capture nonlinearity.

B.constant diversification:

a/ definition:

It is similar to summation,but subtracts fixed percentage from overall figure.

b/ advantages:

△simplicity

△recognition of diversification effects

c/ disadvantages:

△The fixed diversification affect is not sensitive to underlying interactions between components.

△Do not capture nonlinearity.

C.variance-covariance:

a/ definition:

It is weighted sum of components or basis of bilateral correlation between risks.

b/ advantages:

△summarizes the interdependencies across risk types

△better approximation of analytical method

△relatively simple and intuitive

△provides a flexible framework for recognizing diversification benefits

c/ disadvantages:

△Estimates of inter-risk correlation is difficult to obtain.

△Do not capture nonlinearity.

D.copulas:

a/ definition:

Combining marginal distributions through copula functions.

b/ advantages:

△more flexible for nonlinearity

△allows for nonlinearities

△higher order dependency

c/ disadvantages:

△Parameterization is very difficult to validate.

△Building a joint distribution is very difficult.

E.full modelling/simulation:

a/ definition:

Simulating the impact of common risk drivers on all risk components and construct the joint distribution of losses.

b/ advantages:

△theoretically the most appealing method

△potentially the most accurate method intuitive

△intuitive

c/ disadvantages:

△Practically it is the most demanding in terms of inputs.

△It is very high depending on IT.

△It is time consuming.

△It can provide false sense of accuracy.

⑶range of practices in the choice of aggregation methodology:

①more than 60% banks→variance-covariance approach

②less than 20% banks→full modeling/simulation approach

⑷supervisory concerns relating to risk aggregation:

①Meaningful aggregation of risk necessarily involves compromises and judgement to augment quantitative methods.

②Many supervisors are sceptical as to the validity of the size of diversification benefit estimates and do not accept them for supervisory use.

③A possible drawback of the more sophisticated methodologies is more of a behavioral nature.

5.Validation of internal economic capital models:

⑴definition of validation:

All the processes that provide evidence-based assessment about a model´s fitness for purpose.

⑵What validation process are in use:

①qualitative processes(A→B→C→D→E→F):

A.use test

B.qualitative review

C.systems implementation

D.management oversight

E.data quality checks

F.examination of assumption(sensitivity testing)

②quantitative processes(A→B→C→D→E→F):

A.validation of inputs and parameters

B.model replication

C.benchmarking and hypothetical portfolio testing:

It may provide little comfort that the model actually reflects "reality".

D.back testing

E.profit and loss attribution

F.stress testing:

a/ stressing of the model

b/ comparison of model outputs to stress losses

⑶supervisory covers relating to validation

6.Issues of economic capital model:

⑴dependency modeling in credit risk:

①A particularly important and difficult aspect is the modeling of the dependency.

②The main concern centers on the accuracy and stability of correlation estimates,particularly during times of stress.

⑵counterparty modelling in credit risk:

①Need to consider:

using additional methods to help cover all exposures

②Need to be overcome:

wrong-way risk,market risk-related challenges,credit risk-related challenges,operational risk-related challenges,differences in treatment between margined and non-margined counterparties,and a range of aggregation challenges

⑶interest rate risk in the banking book:

①the main challenges:

There is a need to model indeterminate cash flows on both the asset and liability side due to embedded optionality in many banking book items.

②Most banks use simulation approaches for determining their economic capital.

③Others:

optionality in the banking book,bank´s pricing behavior,the choice of stress scenarios

7.BIS recommendations:

⑴use of economic capital models in assessing capital adequacy

⑵senior management

⑶transparency and integration into decision-making

⑷risk identification

⑸risk measures

⑹risk aggregation

⑺validation

⑻dependency modeling in credit risk

⑼counterparty credit risk

⑽interest rate risk in the banking book

大浩浩的笔记课堂之FRM考试学习笔记合集