Chapter 4 - Economic Capital and RaRoC-1 (1) - Fundamentals of Financial Risk Management Chapter 4 Economic Capital and RaRoC Author Clifford V Rossi

Chapter 4 - Economic Capital and RaRoC-1 (1) - Fundamentals...

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Fundamentals of Financial Risk Management Chapter 4 Economic Capital, and RaRoC Author: Clifford V. Rossi John Wiley and Sons 1
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Fundamentals of Financial Risk Management SifiBank Capital Allocation SifiBank Holding Company operates three major business lines; SifiBank, comprised of retail and commercial banking activities, SifiInvestment Bank conducting trading, sales and corporate finance activities, and SifiAsset Management and Brokerage. SifiBank’s annual strategic planning session is underway and the heads of the three divisions along with the rest of the Executive Committee (EC) including the Chief Risk Officer, CEO, President and CFO, among others will be reviewing last year’s performance of the operating units to gain insight into where the company should deploy its capital for the coming year. A high level summary of how each unit performed is provided in Table 6-1. 2
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Fundamentals of Financial Risk Management SifiBank Capital Plan The SifiBank Holding Company has a required level of capital to total assets of 10%. This could be either a regulatory requirement or an internally determined level of capital necessary to maintain some target rating for the company; e.g., AA. The holding company allocates its capital among the three business units in this case according to its asset base. Those capital charges are shown in the 4th column of Table 6-1. Due to the fact that the investment bank represents nearly two- thirds of the entire company based on asset size, its’ capital charge of $65 billion is considerably higher than either of the other operating units. 3
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Fundamentals of Financial Risk Management ROE an Effective Metric? The new CRO is asked what she thinks about the risks to the business plan if additional capital were to be deployed to SifiInvestment Bank while shrinking the other two business units. She comments that the return on capital approach does not take into consideration the underlying risk of the individual business units and therefore is an unfair comparison to make. At this point the head of SifiInvestment Bank sarcastically comments that ROE calculations have been around the industry for decades and what exactly would the CRO propose in its place? 4
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Fundamentals of Financial Risk Management Capital Allocation Criteria The fundamental problem the CRO states is that losses in each business units not only vary across units but the likelihood of losses can and will vary substantially driven by a number of economic and business forces. The key to understanding the risk profile of each business unit is to generate a loss distribution for each division. A starting point for this discussion is trading losses in SifiInvestment Bank. To make her point the CRO provides the EC Figure 6-1 which shows a hypothetical distribution of losses for SifiInvestment Bank.
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