I was asked yesterday about capital charging – and I started talking about transfer pricing. Whoops.
Without going into a full description of banking capital, I would like
to set out a few basics on capital charging, my philosophy on how it
should be done and (tomorrow) some of the effects of this on the
current system.
Banking Capital
The first decision you need to make is whether to use economic,
regulatory or total capital. In deciding the level of total capital, it
should be above (by a certain margin) whichever of economic or
regulatory is the higher. If we assume that regulatory capital is the
higher (a fairly safe assumption) you get the following:
Total Capital > Regulatory Capital > Economic Capital
The reason for this fairly simple – if you are operating below your regulatory capital then the regulators will (or should under the law) insist that you increase your capital level or they will move in and shut you down. Regulators normally insist on more capital being held than is conventionally prudent, and the economic capital value is what you would choose to hold if you were being conventionally prudent (i.e. within your risk appetite).
The important question when internally charging for capital is which of these to use as the correct value for charging?
Which to use?
So – which of these should be bank use? The quick answer is that really, there is no choice. The bank holds a sum of capital and the cost for that capital will need to be met by the entire bank – at some stage or another. The real question is how.
The best way to illustrate this is to use an example where regulatory and economic capital are out of whack – housing loans is probably the best example at the moment, as shown here. For example, let’s say you decide to use economic capital in the allocation to the business units. Your risk model shows that the correct capital weight for your portfolio of home loans is, say, 5% – as they are (or were if you are in the US) very safe loans. So, using the magic number 8, you allocate a capital charge of 0.4% to the cost of a home loan. Easy.
Problem is, of course, that with the Basel II Accord the effective regulatory minimum is about 10% and with APRA’s flaw floor it is about 20%. If you only allocate 0.4% to the loan, you, as a bank, need to hold an additional 0.4% to meet the Basel II minima and a further 0.8% to meet APRA’s requirements.
On top of that the bank will normally hold an additional capital amount to add a margin of safety above APRA’s requirements, meaning the capital charge would be more than triple the “correct” (i.e. economic) value.
So, you decide to use total capital. The issue then is that the home loans unit is effectively being penalised for what amounts to over-prudence by the regulators and the bank, giving an incorrect view of its risk – driving pricing upwards and reducing competitiveness. This would result in the non-regulated lenders having a distinct advantage over the regulated ones.
Thinking of that, then, you decide to go with economic. What happens with the rest of the capital, then? You still need to hold it and to pay the cost of it. The question is how to allocate it.
Allocation
To get down to some numbers – let’s say that you run a small retail bank with a typical spread of lending and you have an effective economic capital model. One third of your lending is for home loans, one third for (retail) revolving facilities and one third corporate. You have $100m in total capital.
Your capital allocation table may look something like this:
$m Home Loans Revolving Corporate Surplus Economic 10 20 15 55 Regulatory 30 25 30 15 Total 33 33 33 0
In this example I have simply allocated the total capital on the basis of assets – the simplest method.
You can see the problem with this straight away – the home loans area is being hit with a capital charge 3.3 times the “correct” amount, Corporate is slightly more than double and the Revolving area is being hit the least of all. This is likely to mean that the Revolving lending area is being given a relative advantage in the organisation that may drive excess lending and unbalance the portfolio.
A better way, then, would allocate in such a way that the effects of the allocation process was to not imbalance the portfolio – to do it on the basis of loading up the economic number to get to the total number. The best way to explain is to draw another table:
$m Home Loans Revolving Corporate Surplus Economic 10 20 15 55 Regulatory 30 25 30 15 Total 22.2 44.5 33.3 0
The Economic and Regulatory numbers have been left unaffected, as you can see (these are externally determined), but the total capital has now been allocated based on an increment to the economic capital charge – meaning there is no “real” misallocation.
There is an additional possibility – where regulatory capital for an area is higher than total capital (as for home loans above), but this can be effectively ignored under this methodology as the regulatory number just becomes an amount that your total capital, at the whole bank level, cannot be allowed to fall below. It is a burden you need to share, but not allocate.
Overall, of course, this needs to be a dynamic process, with the “mark-up” adjusted regularly. If your business is not changing much, then it could be re-balanced annually. Better, though, to do it monthly so any changes are regular and small.
Result
The results of using this method are simple – you allocate the full amount of capital to all areas of the business without causing an imbalance in the business itself, nor do you provide new incentives for “gaming” among the business lines – reclassifying something in the business as something else. The effects on the economy, however, are something else entirely and they will be looked at tomorrow.
5 comments
8 April, 2009 at 19:50
Penguinunearthed
Another way of allocation which I’ve seen used in general insurance (where regulatory capital is probably less risk based than bank capital between lines of business) is to use a marginal allocation – the intention being that you allocate capital based on the marginal impact of adding the line of business.
I need to think it through better to explain it, but it’s probably a more sophisticated again approach than in proportion to economic capital.
8 April, 2009 at 23:44
Andrew
I would agree and I have seen that approach argued for, but not used, in a bank environment. It would be good to see a full explaination somewhere.
9 April, 2009 at 02:35
PEVIKO
Let me say it upfront: I always enjoy discussions related to capital as it seems to be one of the most confusing topics in the industry :-) For performance measurement purposes (and ultimately insentives), I don’t believe total capital is adequate. Total AVAILABLE capital does not only include risk capital (wether economically measured or based on regulatory rules) but also capital for growth, “buffer” capital, signalling capital, ratings target based capital etc. etc. (some of these are of course “overlapping”). Optimally, businesses should request (be asigned) ex-ante risk capital and this would need to be compared to ex-post used capital, after accounting for meeting return targets. The cost of ex-ante risk capital should be born by the business. Group treasury would be then responsible for managing the “surplus” capital. It also would determine the proper transfer price which effectively becomes the cost of internal capital.
What the proper measure for “risk capital” should be is yet another question. As long as regulatory capital is a proper approximation to the real inherent risks, reg cap could be justified. But who holds an “infinitely diversified” portfolio with “asymptotically single factor” sensitivity on which regulatory capital is based ???
Thus, economic capital seems to be a better choice. But then if the target of economic capital is to ensure “going concern” then effectively the risk capital should be more something like regulatory capital+economic capital. The reasoning being that regulatory capital can be regarded as a cost of being in business whereas economic capital is the cost of staying in business (as a going concern). If the intention is to maintain normal business operations 99% of the time, the the organization has to make sure that there is enough capital ABOVE regulatory capital to absorb 99% of the cases. In practice however this approach would be prohibitevly expensive, and thus a middle ground is to be found. The real story is even more convoluted if one wants to come up with an all-round consistent approach. That’s why the majority of organizations I have worked with so far, rather resort to some simple rules-of-thumb or some heuristics to just make it work.
9 April, 2009 at 19:03
Penguinunearthed
Peviko, I agree that companies effectively need to hold capital above regulatory capital (whether or not the regulatory capital is risk based). I generally call that target surplus. But what to do if the regulatory capital is far from risk based when pricing products? Should products be forced to earn a return on something that isn’t risk based? One of the advantages of being part of a diversified company could be that you can appropriately price products for their economic risk, rather than their regulatory risk.
9 April, 2009 at 21:42
PEVIKO
The first and foremost reason for regulatory capital is protection of the financial system, and was not designed with other purposes in mind. That’s why I believe regulaty capital should be treated as a general cost.
Compare for example Solvency II and Basel II. There are some relevant differences which stem from the fact that Basel II is about SYSTEMIC risk whereas Solvency II is about protection of the the policy holders. Solvency II is thus much more risk based than Basel II.
Also, some regulators argue to abandon the current regulatory capital approach in favor of a much simpler model used in the past and simply rely on some core ratios. In such an environment, systemic risk might be significantly reduced, but reg capital would but anything else but reflective of the true economic risk.