An Introduction to Economic Capital
Incisive Media, June 2009
With the Basel II and Solvency II framework in place, all types of financial intermediaries are preparing to implement economic capital measurement at some level of granularity.
SUMMARY
This new addition identifies the basic building blocks for economic capital measurement. It familiarises and trains a newcomer to the economic capital building blocks, computation approaches and taxonomy, risk measures, risk aggregation, distribution, correlation and dependency structures, risk mitigation, simulation and basic modelling techniques necessary for an institution to invent their own techniques and parameters for modelling economic capital for various types of risks.
The primer format will enable new entrants to quickly grasp the fundamental concepts, and covers:
- Economic capital: the purpose and objectives
- Credit risk
- Insurance risk
- Market risk
- Operational risk
- Liquidity risk
- Correlations and approximations
Recommended for risk managers, compliance officers, information technology planners and implementers, front and middle office personnel and students of Financial Engineering and Financial Risk Management courses.
1. Economic Capital
Introduction
Economic capital distribution
Regulatory capital vs economic capital
Economic capital aggregation
Coherent measures of risks
Correlation
Dependency structures
Diversification
Risk concentration
Copula
Risk aggregation
Case studies of risk aggregation and integration
Issues of model risk
Limitation of economic capital modelling
Conclusions
2. Credit Risk
Introduction
Extending Basel II model to economic capital
Concentration risk
Building transition matrices
Credit spreads
Theoretical variables to model credit spreads
Additional variables to model credit spreads
Unbundling the shape of credit risk curve
Structural approach to model credit spreads
Reduced form approach to model credit spreads
Counterparty risk
Simulation
Modelling risk mitigants
Correlation
Copulas
Dependency structures
Implied correlation
Mixture models
Conclusion
3. Insurance Risk
Risks in insurance
Technical provision
Underwriting risks
Investments and ALM risks
Solvency II overview
Capital allocation
Mortality risk
Longevity risk
Disability risk
Expense risk
Lapse risk
Life catastrophe risk
Provisioning risk
Catastrophe risk
Reinsurance risk
ALM risk
Conclusion
4. Market Risk
Introduction
Risk factors
VaR methodologies
Modelling exposures
Modelling risk distribution
Correlation
Stress-testing
Conclusion
5. Operational Risk
Introduction
Overview of loss distribution approach
Issues and challenges of loss data
Extreme value theory
Models and data distributions for operational risk
Modelling insurance
Aggregation of losses
Conclusion
6. Liquidity Risk
Introduction
Systemic risk
Factors
Market liquidity
Funding liquidity
Contingent liquidity
Conclusion
7. Correlations and approximations
Introduction
Financial assets are not “normally distributed”
Distribution and estimators
Dependency structures
Copulas
Stress-testing and model validation
Conclusion
Mohan Bhatia MS, FRM is Managing Principal heading Risk, Performance and Compliance Practice at Oracle Financial Services Consulting spearheading consulting for Basel II, Solvency II, Risk quantification and Compliance for BFSI. Mohan has provided consulting to tens of institutions in Americas, Europe, Middle East, Africa and Asia Pacific enabling them to measure and manage risk, performance and compliance. Mohan is co-editor of Journal of Risk Model Validation.
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