Economic Capital - A Unifying Approach

With the advent of new risk-based regulations for financial services firms, specifically Basel 2 for banks and Solvency 2 for insurers, there is now a heightened focus on the practical implementation of quantitative risk management techniques for firms operating within the financial services industry. In particular, financial services firms are now expected to self assess and quantify the amount of capital that they need, to cover the risks they are running. This self-assessed quantum of capital is commonly termed risk, or economic, capital. Economic capital has the potential to make financial services firms more risk-aware in their capital management, enabling investors and regulators to easily compare financial strength and profitability across business lines and sectors.

The first part of the presentation is based on Srinivasan and Tapadar (2008) and Porteous and Tapadar (2005). It focuses on the implementation of economic capital techniques to show how economic capital can be calculated for companies offering different financial products with varying risk profiles. A stochastic approach, using graphical models, is used in conjunction with examples of a capital repayment mortgage, a lifetime mortgage and a life insurance annuity product. This will demonstrate economic capital as a tool that not only meets the needs of all interested parties, but also unifies capital calculation techniques across all financial services firms, irrespective of their line of operation.

The second half of the presentation is based on Porteous and Tapadar (2008) which advances the techniques further to quantify the impact of capital structure and capital asset allocation on a firm's economic capital and risk adjusted performance. It is demonstrated that under certain circumstances, gearing up Tier 1 capital with Tier 2 capital can be in the interests of the firms' Tier 1 capital providers. The technique is again generic and can be applied to any financial services firm.