Credit risk is one of the most important risk faced by banks and financial institutions. Therefore, computation of economic capital for credit risk is important aspect of risk management.
For any bank or financial institution’s effective capital management, the starting point is the regulatory capital, i.e., the capital computed in accordance with Basel III capital adequacy framework. After this, the next step is development of economic capital framework.
In banking industry, the economic capital refers to the amount of equity required by a bank to cover a maximum potential future loss based on probabilistic assessment. Unlike traditional capital, economic capital does not take into account the capital held by the bank, it rather takes into account the capital required by a bank at a certain level of risk. Therefore, economic capital is a forward-looking and risk-based measure of capital adequacy of a bank.
Importance of Economic Capital
Banks use economic capital model as a tool primarily for two purposes: capital allocation and performance assessment. They allocate economic capital to each business line to produce optimum return, in line with the strategy, and risk appetite of the bank. Banks monitor capital usage regularly and take appropriate mitigating measures if capital usage exceeds the limit. Also, capital usage metrics are set and performance of business lines are evaluated against such metrics.
Economic Capital for Credit Risk
Basel Committee on Banking Supervision has published research paper entitled “Range of practices and issues in economic capital frameworks” in March 2009. As per the paper, one can assess the success or failure of an economic capital framework in a bank by looking at how business line managers perceive the constraints economic capital imposes and the opportunities it offers in the following areas:
- credit portfolio management;
- risk-based pricing;
- customer profitability analysis, customer segmentation, and portfolio optimisation; and
- management incentives.
Computation of Economic Capital for Credit Risk
Frequency of loss in banks and financial institutions generally follows a lognormal distribution as shown in figure below). The lognormal distribution skews towards the right. The distribution frequency increases to its mode, and decreases thereafter.
Banks and financial institutions compute expected loss which is the average or mean point of the distribution. Banks and financial institutions provide for such loss in the books of accounts by way of provision for expected loss. They use following formula for computation of expected credit loss :
Probability of Default of the counter-party (PD) X Loss Given Default (LGD) X Exposure at Default (EAD)
However, the possibility of loss still remains beyond mean point. Therefore, regulators require banks and financial institutions to maintain economic capital to meet the loss beyond the mean point of the loss distribution up to desired confidence level.
Economic Capital Model
Banks and financial institutions compute Economic capital for counterparty credit risk by using Monte Carlo Simulation Method or Value-at-Risk Method. For credit portfolio risk modelling, Banks and financial institutions often use Moody’s/KMV, CreditMetrics, and CreditRisk+.