AIM35.3: Describe theconstraintsimposed andtheopportunities offered by economiccapitalwithin thefollowingareas:
* Credit portfolio management
* Risk based pricing
+ Customer profitability’analysis
+ Managementincentives Credit Portfolio Management
Constraintsimposed:
* Credit quality of each borrower Lsdetermined ina portfoliocontext, notonastandơ
alone basis.
• Aloan’sincrementalrisk contribution is usedtodeterminedieconcentrationof the loan portfolio.
Opportunitiesoffered:
* Theprocessallowsonetodetermineappropriatehedgingstrategies to use in reducing portfolioconcentration.
• Creditportfoliomanagement hecomesa meansfor protecting against riskdeterioration.
Risk-Based Pricing
Constraintsimposed:
* Pricingdecisionsarebasedonexpectedrisk-adjusted returnoncapital(RAB.OC), so dealswillberejected ifthey arelowerdianaspecificRAROC.The proposedinterestrate isdetermined bydieamountofeconomiccapitalallocated to thedeal.
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Topic35 CrossReferencetoCARPAssignedReading—Basel Committeeon Banking Supervision
• Pricing decisionsinclude: (1)costoffunding, (2) ejectedloss, (3)allocated economic
capital,and (4)additional return required byshareholders.Therefore,aminimum interest race isdeterminedthatwillincreaseshareholdervalue,
Opportunitiesoffered:
• Canbe used tomaximize the bank’sprofitability.Forexample,some pricing decisions may need tobeoverridden becausecertain customerrelationshipsare moreprofitable
(atalower prioe/interestrare) ordesirable froma reputationalpoint ofview.Ofcourse,
suchoverridesarenot takenlightlyand requireupper managementapproval,aswell as
rigoroussubsequent monitoring.
Customer Profitability Analysis
Constraintsimposed:
* Theanalysisiscomplicatedin that manyrisks need tobeaggregatedat thecustomer
level.
• Customers need to besegmentedin termsof ranges of(net) return per unit ofrisk; the underlyinginformationisdifficult tomeasure and allocate.
Opportunitiesoffered:
* Assuming that themeasurementobstacles have been overcome,dieanalysiscan beeasily used todetermineunprofitableoronly slightly profitablecustomers.Suchcustomers could hedroppedandeconomiccapital allocated to diemoreprofitablecustomers.
* Economiccapitalis usedin maximizingthe risk-retnrn trade-off(throughrelative risk- adjustedprofitabilityanalysis ofcustomers).
ManagementIncentives
Constraintsimposed:
* Studiesshowthatcompensationschemesarea minorconsiderationintermsof the actual usesofeconomiccapital measuresat the businessunitlevel.
Opportunitiesoffered:
• It issuggested thatmanagement incentives is theissuethatmotivatesbank managersto
participatein the technical aspectsof the economiccapitalallocation process.
CrossReferencetoCARPAssignedReading-Basel Committeeon Banking Supervision
KEY CONCEPTS
AIM35.1
Amultitudeofchallengesexist wiiJiin the economiccapitalframework drat involve:
(1)defining riskmeasures,(2) riskaggregation,[3}validation ofmodels, (4) dependency modelingincredit risk,(5)evaluatingcounterpartycreditrisk,and(6)assessinginterestrate riskin thebankingbook.
AIM35.2
Thereareten BISrecommendations that supervisors should consider tomake effectiveuse of risk measures.
AIM35.3
Anumber ofspecificconstraintsimposedand opportunities offered byeconomiccapital existwithin theareasofcredit portfoliomanagement,riskbased pricing,customer profitability analysis, andmanagement incentives.
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Topic35 CrossReferencetoGARPAssignedReading—Basel Committeeon Banking Supervision
CONCEPT CHECKERS
Whichof thefollowing risk measuresis dieleastcommonly usedmeasurein the practice of risk management?
A. Valueat risk.
5. Standarddeviation.
C. Expectedshortfall*
D. Spectral riskmeasures.
Whichof thefollowingaggregation methodologiesischaracterizedbygreatdifficulty in validatingparameterizationand buildinga jointdistribution?
A. Copulas.
B. Constantdiversification. C. Variance-covariancematrix.
D. Fullmodeling/simulation.
Whichof thefollowing model validation processesisspecifically characterizedby the limitation thatitprovideslittlecomfort that the model actuallyreflectsreality?
A. Backtesting.
B. Benchmarking.
C. Stresstesting.
D. Qualitativereview.
Whichof thefollowingcategories ofBIS recommendationsspecificallyreferstodie needtoconsider usingadditionalmethods,suchasstresstesting, to helpcoverall exposures?
A. Riskaggregation.
B. Counterpartycredit risk.
C. Dependency modelingincreditrisk.
D. Interestrateriskindiebankingbook.
The use of which of thefollowingitems is meantmorefor protecting against risk deterioration?
A. Risk based pricing.
B. Managementincentives.
C. Credit portfoliomanagement.
D. Customer profitability analysis.
I.
2.
3.
4.
5.
CrossReferencetoGARPAssignedReading—Basel Committeeon BankingSupervision
CONCEPT CHECKER ANSWERS
1. D Spectraland distortedriskmeasuresarctheleastusedof the fourmeasuresandarcmainlyof academicinterestonly.
2. A Copulashavetwonotabledisadvantages:{1)parameterizationisverydifficulttovalidate,and (2)buildingajoint distributionisvery difficult.
3. B Withbenchmarkingand hypotheticalportfoliotesting, theprocesshas its limitations because itcanonlycompareone model against another and mayprovidelitdccomfort that the modelactuallyreflects Allthat the processisabletodoisprovidebroad comparisonsconfirmingthatinputparametersormodeloutputsarcbroadly comparable.
4. B Therearctrade-offstobeconsidered whendecidingbetween the available methodsof measuringcounterpartycreditrisk.Additional methods, suchasstresstesting,needtobe usedtohelpcoverall exposures,
5, C Creditportfoliomanagement isusedasameanstoprotectagainstrisk deterioration.Tn
contrast,risk basedpricingisusedtomaximizethe bank’sprofitability;customerprofitability analysisisusedtodetermine unprofitableoronly slighdy profitablecustomers;and
management incentivesarcusedtomotivatemanagerstoparticipateinthe technicalaspects oftheeconomiccapitalallocationprocess.
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ThefollowingisareviewoftheOpcraiiojialandInLegraiedRisk Management, principlesdesignedtoaddress
theAIMsiaiemettLSsetforth layGART®.Thistopicis also covered in: