The material below comprises excerpts from books by Dr. Johnathan Mun, our CEO and founder, such as Readings in Certified Quantitative Risk Management, 3rd Edition, and Quantitative Research Methods Using Risk Simulator and ROV BizStats Software Applying Econometrics, Multivariate Regression, Parametric and Nonparametric Hypothesis Testing, Monte Carlo Risk Simulation, Predictive Modeling, and Optimization, 4th Edition ( All screenshots and analytical models are run using the ROV Risk Simulator and ROV BizStats software applications. Statistical results shown are computed using Risk Simulator or BizStats. Online Training Videos are also available on these topics as well as the Certified in Quantitative Risk Management (CQRM) certification program. All materials are copyrighted as well as patent protected under international law, with all rights reserved.

This book looks at some practical tools—quantitative models, Monte Carlo risk simulations, credit models, and business statistics—utilized to model and quantify regulatory and economic capital, measure and monitor key risk indicators, and report all the obtained data in a clear and intuitive manner. It relates to the modeling and analysis of asset liability management, credit risk, market risk, operational risk, and liquidity risk for banks or financial institutions, allowing these firms to properly identify, assess, quantify, value, diversify, hedge, and generate periodic regulatory reports for supervisory authorities and Central Banks on their credit, market, and operational risk areas, as well as for internal risk audits, risk controls, and risk management purposes.

In banking finance and financial services firms, economic capital is defined as the amount of risk capital, assessed on a realistic basis based on actual historical data, the bank or firm requires to cover the risks as a going concern, such as market risk, credit risk, liquidity risk, and operational risk. It is the amount of money that is needed to ensure survival in a worst-case scenario. Financial services regulators such as Central Banks, Bank of International Settlements, and other regulatory commissions should then require banks to hold an amount of risk capital equal at least to its economic capital times some holding multiple. Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a prespecified probability (e.g., usually defined as 99.00%). Therefore, economic capital is often calculated with Value at Risk (VaR) type models.

Capital modeling in banks has surged as a necessity for the larger international financial institutions, which have discovered that the regulatory approaches taken by regulators were too basic and mainly not risk based. For example, credit risk capital requirements under Basel I were just a percentage (8% times another multiplier) of the volume of operations. This measure, which was very easy to calculate, was not risk sensitive, other than the differentiation of broad asset types. Therefore, complex banks found these capital requirements to be very inefficient in terms of capital planning, pricing, and leveraging limits and targets. With the evolution of the use of statistical models and available data—especially in market risk measurement—regulators started accepting internal capital models developed by the big international financial institutions. Accordingly, in 1996, an amendment was introduced to the Basel Accord (still Basel I) that allowed certain qualifying banks to calculate and hold capital in line with their internal models. To differentiate these measures of capital, banks started calling these internal calculations “economic capital,” because it had a very close relationship with the real economics of the business, whereas “regulatory capital” was the requirement mandated by regulators. As the business evolved, and regulations became more ample, complex financial institutions started relying more on their economic capital models for the measurement and management of risks, while simultaneously having to hold regulatory capital. In most cases, the differences between these two kinds of capital for the same risk were very significant. This fact was one of the primary motivators of Basel III/IV, prompted mainly by a request from the more complex banks that the International Standards and, hence, banking regulations allow them to use their economic capital models to allocate regulatory capital. In other words, one of the outright motivations for the Basel III/IV reforms was to close the practical gap between economic and regulatory capital.

As Basel III/IV started to be implemented in most countries, the new regulatory paradigm established that banks—not just complex international financial institutions—must have IMMM processes for all material risks, and calculate and allocate economic capital for each and every one of these risks. For any given bank, these risks are defined by regulations as identified in the Basel Core Principles: credit, market, operational, liquidity, interest rate, strategic, reputational, securitization, and so on. In this light, banks of any size, in virtually every country, need to identify, measure, monitor, and mitigate all these risks, and calculate, evaluate, and allocate economic capital for each. This chapter discusses a set of simple approaches with straightforward tools that allow banks of any size and complexity to generate information for the management (the IMMM process) of these risks, and for the calculation of economic capital based on the available balance sheet and regulatory information. In light of these International Standards, which are now formal regulations in virtually every country in the world, we utilize a spectrum of basic and more complex approaches to generate an economic capital model calculated on the formally defined risk drivers in each case and providing for risk-sensitive capital results for each relevant risk. Additionally, for each risk, through a set of basic information, a set of key risk indicators is generated and combined with the capital model results to produce relevant risk reports. Since regulations still require many instances of regulatory capital, such calculation is still provided along with Basel Standards as another useful output of the software tools. Finally, The Basel Committee differentiates credit, market, and operational risks from the rest, defining these three as the most relevant in any given financial institution. According to the Three Pillar design of Basel III/IV, these are known as Pillar I risks. Under Basel III/IV, economic and regulatory capital can be unified for Pillar I risks. In other words, for these three risks (credit, market and operational), economic capital models are given by the Basel Accord as a way to generate some standardization of methodologies and comparison among banks and countries.

For credit risk, the traditional approach for Basel I regulatory capital (still available as a basic choice in Basel III/IV) is to calculate 8% of outstanding loan volume, multiplied by a factor depending of the type of asset treated (100% for uncollateralized loans, 50% for mortgages, 20% for interbank, etc.). This approach, however, does not differentiate by risk within each category. In order to create a more risk-sensitive approach, Basel III/IV incorporated the main logic of portfolio models, where capital is the amount required to cover unexpected losses. Unexpected losses, in turn, are calculated as the residual given by the difference between the mean and the confidence interval of a loss distribution function.



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