The Case for Fully Integrated Models of Economic Capital
Friday, 27 February 2009 | 
Risk - Research
By Alexander McNeil, Professor, Maxwell Institute for the Mathematical Sciences, Edinburgh EH14 4AS, UK,
& Axel Kirchner, University of Edinburgh and Gavin Lee Kretzschmar, University of Edinburgh - Accounting and Finance
Economic capital models are potentially powerful tools for enterprise risk management (ERM), and for the supervisory review process (Pillar 2) of the Basel II and Solvency II regulatory capital frameworks. We argue that, to fulfill this potential, economic capital models need to be fully integrated and to go beyond the more modular approaches that dominate Pillar 1 methodology. In a modular approach capital is determined at business-unit or risk category level (e.g. market, credit and liquidity risk separately) and aggregated ex post by simple summation or correlation-adjusted summation; in a fully integrated approach aggregation occurs implicitly by relating all risks to a common set of fundamental risk drivers.
[The paper] explain(s) how calibrated economic scenario generation lies at the heart of a fully integrated approach to modelling the risks on the asset side of a firm's balance sheet and discuss how stochastic scenario generation gives the ideal framework for exploring the diversification benefits that different units or asset classes bring to an enterprise. We explain how this approach allows us to understand the sources of tail risk and gives us a platform for integrated stress testing, sensitivity analysis, and the allocation of capital to business units for risk-adjusted performance comparisons.
This is draft version 3, publication date February 3rd 2009, make sure it is this version you are downloading!
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1317251
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Comments
Scenario Based Enterprise Capital Models
- Why Banks are Under-Capitalized
I understand this is paper 2 in a series of 3; paper one is being completed by Professor McNeil and will be a the key contribution to a REvolution in thinking about Economic Capital which does seem to progressing right now.
Abstract: (of the paper referred here)
The concept of economic capital is clear; it is the capital charge that a financial institution (bank or insurance company) requires in order to limit the probability of bankruptcy to a given confidence level over a given time horizon. There is however little consensus about the most robust methodology for its calculation. In terms of Pillar 2 of Basel II, the interactions between risk factors need to be calibrated to real world conditions and combined with Balance Sheet asset positions to determine enterprise economic capital at a given confidence level.
We derive a typical Eurobank balance sheet and compare the capital effects of using modular and integrated methodologies. We find that, based on 2006 balance sheet positions, banks typically underestimated tail dependency and entered the credit crisis 18% undercapitalised. This capital understatement is, in part, due to a widespread methodological dependence on the modular covariance approach to computing economic capital, resulting in the understatement of multivariate tail dependencies, limited scope for understanding path dependence and risk management actions.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1318264
Multivariate Stress Testing for Solvency II
Alexander J. McNeil
Andrew D. Smith
LINK
Integrated models of capital adequacy
Integrated models of capital adequacy - Why banks are undercapitalised
Gavin Kretzschmar
University of Edinburgh
Alexander J. McNeil
Maxwell Institute for the Mathematical Sciences, Edinburgh, UK
Axel Kirchner
Barrie & Hibbert Limited
Abstract
With the majority of large UK and many US banks collapsing or being forced to raise capital over the 2007-9 period, blaming bankers may be satisfying but is patently insufficient; Basel II and Federal oversight frameworks also deserve criticism. We propose that the current methodological void at the heart of Basel II, Pillar 2 is filled with the recommendation that banks develop fully integrated models for economic capital that relate asset values to fundamental drivers of risk in the economy to capture systematic effects and inter-asset dependencies in a way that crude correlation assumptions do not.
We implement a fully integrated risk analysis based on the balance sheet of a representative Eurobank using an economic scenario generation model calibrated to conditions at the end of 2007. Our results suggest that the more modular, correlation-based approaches to economic capital that currently dominate practice will have led to an undercapitalisation of banks.
a Preprint submitted to a journal November 5, 2009
from Professor McNeil's list of publications
very relevant today