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 looke

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