Module 30: Capital management Flashcards
Solvency Capital Requirement (SCR) under Solvency II
A market-consistent 1-in-200, 1-year VaR performed using a standard formula or the firm’s internal model.
Calculating credit risk capital:
Internal Ratings Based (IRB) approach
Basel II allows banks to categorise and risk-weight their assets based upon credit ratings determined by using their own Internal Ratings Based (IRB) model.
A thorough credit assessment is required, and the methodology needs to be approved by the regulator.
Capital modelling process:
Select the modelling criteria
E.g. exit value as measured by absolute ruin, attaining a certain investment rating or some ongoing business criteria as measured by supervisory intervention.
Multiple criteria should be used.
Capital modelling process:
Identify purpose
A clear purpose is required for the model.
This will influence factors such as:
- whether or not it is assumed that the business remains open to new business or simply run off
- whether contingent management actions will be modelled
- the level of resourcing required
- the accuracy of results.
Minimum Capital requirement under Basel II
Minimum Tier 1 + Tier 2 capital is 8% of RWA (total risk weighted assets).
Capital modelling process:
Choose the simulation approach for each risk
Possible approaches include both deterministic (stress scenario) and stochastic (eg parametric, empirical) approaches.
The approach chosen will depend on cost/time considerations and the benefits gained.
ICMs should aim to cover:
All risks faced by a company,
in a consistent way,
allowing for the interaction between the various risks.
8 Benefits of a dynamic asset-liability model
- improved understanding of the dynamics of the current strategy
- consideration of the impacts of implementing different strategies (eg mix of business)
- examination of the impact of using different sources of capital
- useful for due diligence for corporate transactions
- assesses the risk-adjusted performance of different business units
- determines an optimal asset mix
- helps understand the impact of extreme events
- useful in producing Financial Condition Reports
Define hurdle rate
The hurdle rate of return on capital is a standard against which business activities must be measured.
If a proposed activity does not offer a RAROC above the hurdle rate then that is one basis upon which it might be rejected.
7 Factors which might be used to compare different methods of capital allocation
- complexity and computational intensity (eg game theory)
- ease of communication
- degree to which allocation is affected by the presence of other business units (eg stand-alone)
- degree to which allocation is affected by basis (eg order of allocation in the marginal approach)
- degree to which the method may lead to under-investment business units providing a diversification benefit.
- degree to which method may lead to over-investment in risky business units.
- correspondence with the marginal pricing principle
Economic income created (EIC)
EIC captures the quantity of return generated by a unit fo activity (ie it is a monetary amount, rather than a percentage)
EIC = (RAROC - hurdle rate) x Capital
Economic cost of ruin
Looks at the amount key stakeholders (eg policyholders of an insurance company with depositors with a bank) can be expected to lose in the event of ruin.
This may be expressed as an absolute amount or as a proportion (eg ratio or policyholder benefits).
This is theoretically a better approach than considering only the probability of ruin, but this advantage is usually outweighed by practical problems associated with calculating the economic cost of ruin.
Solvency II
Solvency Capital Requirement
Outline the basis of the standard formula (4)
The standard formula:
- is based on a specific deterministic basis but with some stochastic elements (eg for the valuation of guarantees)
- deals with market risk through limited admissibility of some assets, plus a number of stress tests
- deals with credit risk through limiting exposure to individual counterparties (eg reinsurers)
- deals with underwriting risk by requiring additional solvency margins, generally calculated by reference to business volumes (eg premiums) or risks (eg claims incurred, sums assured)
Under Basel II, a bank’s capital is classed in 3 tiers:
Tier 1
The bank’s equity and disclosed reserves.
Tier 2
Other reserves and various debt instruments.
Tier 3
Certain types of shorter-dated capital (eg unsecured, subordinated debt with a minimum maturity of two years).
Market risk capital under Basel II
determined using either a standardised approach or using asset modelling to calculate a multiple of a 10-day 99% VaR.
Capital modelling process:
Identify and rank risks
The dominant risks will vary by insurer.
This may include: - catastrophe - underwriting - reserving - pricing - liquidity - market - credit - operational risks
Capital modelling process:
Define the risk metrics
These typically include
- VaR or Tail VaR,
- the time horizon and
- the confidence interval.
Shareholder Value (SHV)
SHV assesses the intrinsic economic value of a business as a going concern.
SHV captures the present value of all future cashflows:
SHV = Discounted value of all future cashflows
= Capital x { (RAROC - g) / (hurdle - g) }
Where
g = prospective future growth rate of the business (usually over three to five years).
Aims of Basel III
- strengthened capital requirements for banks
- reduce pro-cyclicality by allowing capital requirements to fall in times of financial stress
- reduce systemic risk by limiting the degree to which holdings in other banks can be allowed for in a bank’s equity
- strengthen short- and long-term resilience against liquidity risk, as measured by the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)
However, it doesn’t deal with the concentration risk arising when banks pursue similar business strategies.
Capital allocation:
Particular care should be taken when: (5)
- using a risk measure that is not coherent
- using different risk measures to calculate the overall requirement and the requirement at unit level
- allocating ‘excess’ capital (eg capital required to support a credit rating)
- allocations change significantly over time
- communicating complex, and potentially unintuitive results
Outline the method used to assess capital requirements:
stochastic model
These can either be univariate or multivariate (both can allow for covariance between the variables).
Scenarios are generated at random and capital calculated on the basis of the results of these scenarios.
Dynamic asset-liability model
One where the asset and liability cashflows are linked by equivalent economic variables (eg inflation).
Basel II definition of operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
This definition includes legal risk, but excludes strategic and reputational risk.