Economic Capital andRAROCChapter23RiskManagementandFinanciallnstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Economic Capital and RAROC 1
Economic CapitalA bank's own assessment of the capital itrequires2RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Economic Capital ⚫ A bank’s own assessment of the capital it requires 2
ModelUsedforEconomicandCapital(SameasRegulatoryCapital)Figure 23.1, page 492ExpectedX% WorstLossCaseLossCapitalLossovertimehorizon05101520303540253RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Model Used for Economic and Capital (Same as Regulatory Capital) Figure 23.1, page 492 -0.2 0 0.2 0.4 0.6 0.8 1 1.2 0 5 1 0 1 5 2 0 2 5 3 0 3 5 4 0 Loss over time horizon Expected Loss X% Worst Case Loss Capital 3
Choice of Parameters● For a bank wishing to maintain a AA-rating, capital is chosen so that Xis about99.95% and time horizon is one yearThis is because statistics from ratingagencies show that an AA-rated companyshould have a probability of only about0.05% of defaulting in one year4RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 Choice of Parameters ⚫ For a bank wishing to maintain a AArating, capital is chosen so that X is about 99.95% and time horizon is one year ⚫ This is because statistics from rating agencies show that an AA-rated company should have a probability of only about 0.05% of defaulting in one year 4
TheBaselIlRegulatoryEnvironmentt(Figure23.2,page493)TotalRiskNon-BusinessRiskBusinessRisk(regulatory capital):(noregulatorycapital)Credit RiskRisk from StrategicMarketRiskDecisionsReputationRiskOperationalRisk5RiskManagementandFinancialInstitutions3e,Chapter23,CopyrightJohnC.Hull2012
Risk Management and Financial Institutions 3e, Chapter 23, Copyright © John C. Hull 2012 The Basel II Regulatory Environment (Figure 23.2, page 493) Total Risk Business Risk (no regulatory capital): Risk from Strategic Decisions Reputation Risk Non-Business Risk (regulatory capital): Credit Risk Market Risk Operational Risk 5