Conventionally, economic capital has been considered as the basis for capital management. This is because of its risk sensitivity and the fact that it appropriately reflects the risk profile of a bank, since the approach and methodology for economic capital computation are defined by banks themselves. Economic capital has been extensively used as the base for risk-based performance assessments. Regulatory capital, on the other hand, has always been considered as a compliance measure – and rightly so, due to its highly conservative nature. Banks lines of business are evaluated on the amount of risk they have added to the business in comparison to the capital allocated to them. There is little or no stress element factored into the computation, since so far regulators have mandated stress testing with respect to regulatory capital only, and not economic capital.
Can the current capital management process handle stress scenarios?
Banks today, guided by regulations such as the Comprehensive Capital Analysis and Review (CCAR), are contemplating on whether economic capital is a true measure of capital planning and performance measurement. The fundamental premise of stress tests is to have banks demonstrate their ability to absorb losses, which involves ascertaining their capital adequacy for aggregated risk quantification under various market stress scenarios.
There is a visible gap in terms of aggregated target economic capital allocated for each line of business against the total aggregated stressed regulatory capital at the bank level, as part of the CCAR exercise. This additional delta remains unaccounted as economic capital. It is not included in the regulatory stress testing exercise and banks are unable to factor in the additional capital need into their internal capital adequacy process (ICAAP); they hold individual business units accountable for the excess capital needs.
So, we have a situation where the various lines of business might be well within their established limits of target economic capital, but contribute to a greater level of stressed regulatory capital. This is due to the potential sensitivity of the risk models to regulatory scenarios. Here is the need to factor in the stress element into the internal capital management process.
What could be the basis for revised capital allocation?
There are two ways to address this gap.
- Banks could consider the CCAR stress regulatory capital as computed for regulatory submissions, and use that as the base for capital allocation and performance assessment of business units.
- Banks can use the stressed risk parameters (like stressed PDs, LGDs, and EADs) from the CCAR framework to compute the stressed economic capital on the existing economic capital framework. This can be the new measure for capital allocation and performance assessment of business units.
The first approach will be easier since it is already being done as part of CCAR, but is not necessarily reflective of a banks risk profile. The second approach is better in this regard, but requires significant changes to a banks risk models and methodology. Both alternatives present some benefits and limitations of their own.
So, what is the way forward?
In the current environment, where banks are treading cautiously and conservatively – and understandably so, it is imperative that the risk-based performance measurement of business units is based on stressed risk (takes into account the various market stress factors while quantifying the risk). This will enable banks to stay competitive, as well as close the gap between regulatory and strategic needs. Also, the intent of the CCAR exercise is to encourage a forward-looking capital management approach that factors in adverse economic scenarios. Consider a scenario where the GDP growth rate is low and the unemployment rate is quite high, or foreign exchange rates are declining. In all these cases, the economic capital should be large enough to cover for any unforeseen adverse economic condition. Banks will eventually be expected to absorb such stressors and make some fundamental changes to their capital management strategies. For a start, they could integrate their CCAR stress testing and capital management process and infrastructure, and periodically calibrate their compliance management strategy on the basis of stress scenarios.
We feel that going forward, allocating stressed regulatory capital for businesses to perform during stressful times should be approached as a forethought, i.e., during the capital planning and management stage. To achieve this, banks will need to redesign their capital management policies, associated business processes, and the technology infrastructure, in order to effectively integrate stress testing with the capital management process.