The need to update the economic capital framework. - Seeker's Thoughts

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The need to update the economic capital framework.

The Need to Update the Economic Capital Framework

Recently, many financial institutions have increasingly utilized economic capital models for internal capital-adequacy assessments. Such processes can supplement examiners in evaluating an institution's risk-sensitive regulatory capital requirements.

However, significant methodological and implementation challenges still exist with economic capital models.

The need to update the economic capital framework

Capital can refer to more than just money. It encompasses not only physical funds but also human and social capital that contributes to overall business health and success. 

They add depth and dimension to economic valuation of capital by expanding businesses' potential. As well as having access to sufficient monetary funds, companies require an established process for measuring risk management as well as developing and implementing capital adequacy assessments in addition to having enough physical funds.

Due to advances in measuring risk, increasing complexity of institutional exposures, and supervisory expectations that institutions develop internal risk-based methodologies for capital-adequacy assessments, an economic capital framework has become essential. 

These processes measure risks that banks are exposed to and attribute capital accordingly. They form part of an institution's overall risk management process and should form part of every decision process involving expansion or contraction of a business line.

These models use various assumptions which must be tested against actual data in order to ascertain risk-adjusted profitability of banks, providing information which helps make better decisions and boost performance. They may also be used by regulators when assessing capital adequacy or risk management practices of an institution.

Many banks have implemented economic capital frameworks to comply with the revised Basel framework, with an aim of creating risk-sensitive regulatory capital requirements and minimizing arbitrage opportunities. It is important to remember, however, that economic capital model and regulatory capital model do not coincide.

An important challenge of implementation lies in accurately representing relevant risks within the model. While some institutions rely on quantitative risk exposure assessments through models, others rely on qualitative approaches like expert judgment or stress scenarios for less quantifiable ones. Data quality issues also present difficulties to implementing an economic capital framework and some institutions struggle with aggregate multiple risk components into one measure of capital adequacy.

The need to update the regulatory capital framework

Economic Capital (EC) is a supplementary measure to regulatory capital (RC), used to assist financial institutions with allocating their resources efficiently. Banks increasingly use economic capital models to assess risk exposures and capital adequacy; however, significant methodological and implementation issues persist. Supervisors should exercise caution when using bank's economic capital calculations because these can often be misleading - for instance by aggregating capital across business segments to overstate an institution's capacity to absorb losses under stress conditions. Examiners must thoroughly scrutinise any institution's EC model so as not overstating an entity's capacity for handling losses even under stress conditions.

Many of the questions raised by CCAR focused on whether current one-year capital requirement setting time horizons were adequate to address climate risks, which tend to materialise over longer time frames than some other risks. Altering this practice would be a fundamental change, necessitating careful consideration of all possible unintended consequences as well as any unique aspects associated with climate risks.

At present, banking and insurance capital frameworks calibrate their microprudential capital requirements over a one-year horizon, taking into account both expected and unexpected losses expected during that period. Furthermore, accounting rules for trading positions and the IFRS 9 accounting standard for credit risk capture to some degree information about future losses beyond these horizons. Insurance capital frameworks incorporate forward looking view of losses into market consistent valuation approaches as well as expected credit losses under IFRS 9.

The PRA is actively attempting to address gaps that create uncertainty about whether banks and insurers are adequately capitalised for climate risks, including banking sector exposures. While evidence presented in this report highlights steps already underway, more work must be done on developing robust yet transparent methodologies for assessing capital adequacy such as more detailed definition of "capital bases" by business lines including full cost of capital analysis as well as impact from risk-adjusted reinsurance coverage.

The need to update the risk-based requirements

Indian economic capital framework is an essential tool for assessing risk and managing balance sheets, yet requires review due to complex risk-based requirements that are underinclusive in some conditions and easily gamed. A new approach should provide greater transparency and resilience - this is particularly relevant following recent global crisis which highlighted vulnerabilities in many risk-based capital frameworks.

Economic Capital (EC) is an essential complement to regulatory capital requirements (RC). EC measures how much capital a bank needs for supporting business-line decisions while RC attempts to set minimum requirements against all risks within an institution.

EC models can also be used to calculate various performance measures, including return on risk-adjusted capital (RORAC) and value-at-risk (VaR). These measurements reveal which business lines make the best use of capital resources within an organization, providing insight into which activities should expand or contract within that firm.

These new tools should be regularly evaluated to ensure accuracy and consistency, and should be connected to an organized approach for identifying risk drivers, positions, and exposures. Failing to do so may create opportunities for errors to arise and can cause discrepancies between inherent risk and measured risk levels.

An effective EC process should be well-documented, with formal policies and procedures covering ownership, development, validation and application of models. It should also allow comparison across scenarios containing differing assumptions as well as differing market risks; stress tests results should also be included into risk-adjusted return on assets (RAROC) calculations or other performance measures.

As financial fragility rises, the European Central Bank (ECB) framework needs to be updated in order to remain accurate and consistent. This requires taking into account a wider array of financial stability risks such as interest rate volatility and exchange-rate policy uncertainty as well as considering new technologies impact and the need for dynamic modeling methodologies.

The need to update the governance of the economic capital framework

Governance of economic capital frameworks is an essential element of effective risk management. This involves setting guidelines to ensure consistency in using and interpreting economic capital; also it encompasses processes for model ownership, development, validation, and application. When taking these factors into consideration it's crucial that firms consider them within their overall risk management framework and governance structure.

"Capital" can refer to various aspects of our lives, from financial resources and investments, such as equity or debt obligations, to human or social capital. For business purposes, "capital" usually refers to monetary investments held by companies, including equity funds and debt obligations as well as real estate holdings - investments which aim to contribute long-term financial health and profitability as well as increase liquidity - two essential components of any successful enterprise.

Economic capital (EC) refers to the amount of capital needed by financial institutions to protect themselves from their risk exposures. Calculations using economic capital take into account factors like expected losses and credit ratings as a more realistic representation of its solvency than regulatory capital requirements alone can provide. Economic capital requirements have become less stringent over time due to technological innovations; as a result, economic capital has increasingly become a popular measure for banking risks.

Regulatory capital requirements, also known as Basel risk-based capital requirements, are the minimum levels of capital required by banking supervisors to cover potential loss-making activities. The newly revised Basel framework seeks to establish more risk-sensitive regulatory capital requirements by reducing regulatory arbitrage at certain institutions and encouraging firms' capital adequacy assumptions to be grounded more accurately within actual risk results.