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September 05, 2008
Rocky Road to Economic Capital Modeling
Economic capital modeling in financial organisations is aimed at determining the capital requirement for its risk taking activities. With the Banks adopting Basel II standards in emnerging markets, many of them are struggling with quantification of capital to be required under the Internal Capital Adequacy Assessment Process ( ICAAP). With the adoption of ICAAP, economic capital model has gained in complexity. The popular building block approach that adds capital allocated for all significant risks has been supplemented by estimations of business line capital requirement and even disaggregations leasding to calculation of exposure wise capital requirement. In other words, in banks with better economic capital models one can actually look at capital requirements at a granular level.
As these models become more and more refined, many issues come to the forefront posing challanges and at the same time opportunities to ICAAP to a higher qualitative standards. Key issues that are being faced in organisations and less debated in the public space are:
a) deciphering the relationship between overall economic capital and its building blocks, b) consistency, accuracy and stability of the models that are employed to measure the underlying building
blocks ; c) the aggregation framework and sub-additivity d) impact of adverse shocks to the estimates ( a coherent stress testing framework at an enterprise wide as well as granular level and e) the process of validation of economic capital, first by the bank internally and then by the supervisors as part of the Supervisory review process . These apart, another significant challange that the banks face is to consistently project such capital requirement over an elongated timespan, without compromising with the robustness of the underlying models.
As the industry evolves new standards over time, the economic capital modeling at this juncture faces key challanges if such modeling has to satisfy the robustness tests econometric models are routinely subjected to.
Establishing the relationship between the composite capital requirement and its components poses a key challange. Are they being estimated correctly? Can they be just added to arrive at a number and if so what about the joint stresses evidenced recently affecting both credit and market risks. Integration of all components into a meaningful and coherent framework is as much a challange as to convince the senior management its utility in day to day business decision making process. The stress testing of such an enterprise risk capital ( economic capital) poses a huge hurdle considering that regulatory guidence on stress testing is limited and most of the stress tests recommended are stand alone tests for risk silos. Composite stress testing of economic capital needs much research, and we are sure to witness lot of activity in this space in academics, bank research units and at the central bank level. Also, the ability to forecast such capital requirement over an extended time horizon will certainly add value to the finding, enabling banks to plan ahead.
On the whole, this is expected to be an explosive and exciting area of exploration in the coming months. As modeling and forecasting techniques improve, economic capital modeling and forecasting will be taken to the next level. The thought process has started with the BIS publishing a consultative paper on economic capital modeling a week back on their website. Risk associations like PRMIA can and should join this consultative process and be part of the though leadership. There is no dearth of excitement in the domain of risk management, but if you ask me, this is going to be one of the most exciting ventures!
Posted by sunandoroy at September 5, 2008 06:30 AM
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