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Tuesday, August 24, 2010
a futile exercise!
I do not know whether there is a practice of calling ‘Bandh’ – as a mark of protest – in other countries! But, I am sure they are a regular part of Indian politics!! But, let us realise….the entire concept of ‘bandh’ is met with a public attitude of resignation and cynicism. In fact, people ‘do not work’ that day, play cricket, feel helpless, stay indoors watching movies, visit relatives/ friends etc
Petrol went up by Rs 3.70 per litre, diesel by Rs 2 and the LPG cylinder became dearer by Rs 35. And they are essential for transportation, daily cooking – a bare necessity – for the common man. I can understand that the crude oil in the international markets have remained ‘high’ for quite sometime. So, I do not know why this late reaction by the ruling alliance?…….Is it because congress controlled ‘coalition’ after last lok sabha elections.Is it because they need not make any more populist moves, having cornered opposition?
Or is it a remedial ‘sound economics’ corrective to curtail fiscal deficit due to subsidy in petrol and diesel prices for long? Whatever may be the reason….the public were put to discomfort, buses burnt, private vehicles attacked, shops ransacked in a move by the ‘united’ opposition to exhibit their strength in holding Bharat Bandh. The losses were to the tune of Rs 10000 crores because of nation not working a full day and prime time on TV occupied and wasted by political (huh?) debates.The concern of ‘daily wage earners’ was totally overlooked. In addition to this, flights to and fro Mumbai were delayed or cancelled, road travel and trains were stopped in the economic capital. Imagine the impact/ losses, if the economic capital Mumbai does not work for a single day?
Nationwide shut-down (due to public fear) forced by the Opposition parties to protest against rising prices may have achieved its aim for a ‘single’ day! Yes, there is inflation touching double digits and the ‘aam aadmi’ (common man) is forced to ‘pay’ to buy the essential commodities! Rising food prices as well as a general inflation are certainly a matter of concern for the public. And, I do agree the opposition parties have a ‘right’ to voice their concern on issues of national importance. In fact, it is their responsibility to do so! But, will a bandh help them in realising their objective other than creating mayhem and chaos. The times have changed now.
The ‘dandi march’ against the British tax on salt or the civil disobedience movement during the course of freedom struggle made sense then but nowadays, the governments being coalition, the responsibility for good governance is laid equally on the Opposition as well as ruling alliance. If the system is faulty, the Opposition has equal responsibility ( even though it is lesser than what ‘ruling alliance’ has) to correct the same.
I wish the Opposition is ‘intellectually’ better equipped to find solutions to the problems instead of creating new ones. There was only ‘loss’ incurred nationwide and it served to be only a aberration. There should be long-standing solutions to the problems and they should target the issues concerning public concern rather than political muscle power.
Petrol went up by Rs 3.70 per litre, diesel by Rs 2 and the LPG cylinder became dearer by Rs 35. And they are essential for transportation, daily cooking – a bare necessity – for the common man. I can understand that the crude oil in the international markets have remained ‘high’ for quite sometime. So, I do not know why this late reaction by the ruling alliance?…….Is it because congress controlled ‘coalition’ after last lok sabha elections.Is it because they need not make any more populist moves, having cornered opposition?
Or is it a remedial ‘sound economics’ corrective to curtail fiscal deficit due to subsidy in petrol and diesel prices for long? Whatever may be the reason….the public were put to discomfort, buses burnt, private vehicles attacked, shops ransacked in a move by the ‘united’ opposition to exhibit their strength in holding Bharat Bandh. The losses were to the tune of Rs 10000 crores because of nation not working a full day and prime time on TV occupied and wasted by political (huh?) debates.The concern of ‘daily wage earners’ was totally overlooked. In addition to this, flights to and fro Mumbai were delayed or cancelled, road travel and trains were stopped in the economic capital. Imagine the impact/ losses, if the economic capital Mumbai does not work for a single day?
Nationwide shut-down (due to public fear) forced by the Opposition parties to protest against rising prices may have achieved its aim for a ‘single’ day! Yes, there is inflation touching double digits and the ‘aam aadmi’ (common man) is forced to ‘pay’ to buy the essential commodities! Rising food prices as well as a general inflation are certainly a matter of concern for the public. And, I do agree the opposition parties have a ‘right’ to voice their concern on issues of national importance. In fact, it is their responsibility to do so! But, will a bandh help them in realising their objective other than creating mayhem and chaos. The times have changed now.
The ‘dandi march’ against the British tax on salt or the civil disobedience movement during the course of freedom struggle made sense then but nowadays, the governments being coalition, the responsibility for good governance is laid equally on the Opposition as well as ruling alliance. If the system is faulty, the Opposition has equal responsibility ( even though it is lesser than what ‘ruling alliance’ has) to correct the same.
I wish the Opposition is ‘intellectually’ better equipped to find solutions to the problems instead of creating new ones. There was only ‘loss’ incurred nationwide and it served to be only a aberration. There should be long-standing solutions to the problems and they should target the issues concerning public concern rather than political muscle power.
The Paris region: France's economic capital
The Paris region: Europe's economic marketplace.
Located at the heart of Europe, the Paris region is France's leading economic region and one of the top markets in Europe.
As France's capital and administrative and political centre, the Paris region is home to nearly 20% of the French population and generates around 29% of the country's wealth, which represents approximately 5% of the European Union's GDP.
Sign up your business for long-term success . During and after the exhibition...
In addition to the economic and technological vitality of the Paris region, the tradeshows held there have added appeal thanks to the excellent turnout of the local business population, including representatives from countless multinational corporations, research centres and the thousands of companies operating in the region, and the participation of the leading contractors in France.
Participating in a Paris region tradeshow is your opportunity to bring your technological and commercial projects to life in France.
Located at the heart of Europe, the Paris region is France's leading economic region and one of the top markets in Europe.
As France's capital and administrative and political centre, the Paris region is home to nearly 20% of the French population and generates around 29% of the country's wealth, which represents approximately 5% of the European Union's GDP.
Sign up your business for long-term success . During and after the exhibition...
In addition to the economic and technological vitality of the Paris region, the tradeshows held there have added appeal thanks to the excellent turnout of the local business population, including representatives from countless multinational corporations, research centres and the thousands of companies operating in the region, and the participation of the leading contractors in France.
Participating in a Paris region tradeshow is your opportunity to bring your technological and commercial projects to life in France.
SCOR, France - Building Economic Capital Models for Solvency II
Following the introduction of the ICAS regulatory standard in the UK, SCOR built a bespoke economic capital assessment tool for its local subsidiary in the UK.
Wishing to capitalize on this experience, SCOR launched a selection process to identify a modelling software solution and a consultancy firm that would help them further develop their economic capital modelling capabilities for the whole P/C group. This was with a view to creating a fully integrated internal model that they could use in anticipation of the implementation of the future Solvency II directive.
EMB's Igloo Professional software and EMB consultancy were selected as an outcome of this process. This project extends the existing relationship EMB has with the firm, since SCOR had already licensed EMB's reserving software, ResQ, worldwide at the time.
EMB UK and EMB France worked very closely on this project, benefitting from local expertise and global experience. During the past year, EMB France has helped SCOR complete the build of its internal model and documentation as well as participating in the selection of capital allocation techniques. The resulting mutual confidence between EMB and SCOR led to further cooperation on satellite projects.
The use of both Igloo Professional and ResQ was perceived as a facilitator to their merger, during the integration of Converium into SCOR, which had also licensed these two pieces of software.
From a consultancy stand point, the quality of our consultants and the proven track record of EMB in risk modelling are appreciated by SCOR and led to continued collaboration between our two firms. This confidence is demonstrated by the agreement of SCOR Group Chief Actuary, Eric Lecoeur, who kindly shared his feedback on the implementation of the SCOR internal model with attendees at a French industry seminar.
The local presence of EMB in the French market further facilitates the relationship with French companies as well as benefitting from a global resource and expertise.
Wishing to capitalize on this experience, SCOR launched a selection process to identify a modelling software solution and a consultancy firm that would help them further develop their economic capital modelling capabilities for the whole P/C group. This was with a view to creating a fully integrated internal model that they could use in anticipation of the implementation of the future Solvency II directive.
EMB's Igloo Professional software and EMB consultancy were selected as an outcome of this process. This project extends the existing relationship EMB has with the firm, since SCOR had already licensed EMB's reserving software, ResQ, worldwide at the time.
EMB UK and EMB France worked very closely on this project, benefitting from local expertise and global experience. During the past year, EMB France has helped SCOR complete the build of its internal model and documentation as well as participating in the selection of capital allocation techniques. The resulting mutual confidence between EMB and SCOR led to further cooperation on satellite projects.
The use of both Igloo Professional and ResQ was perceived as a facilitator to their merger, during the integration of Converium into SCOR, which had also licensed these two pieces of software.
From a consultancy stand point, the quality of our consultants and the proven track record of EMB in risk modelling are appreciated by SCOR and led to continued collaboration between our two firms. This confidence is demonstrated by the agreement of SCOR Group Chief Actuary, Eric Lecoeur, who kindly shared his feedback on the implementation of the SCOR internal model with attendees at a French industry seminar.
The local presence of EMB in the French market further facilitates the relationship with French companies as well as benefitting from a global resource and expertise.
Monday, August 23, 2010
Capital Economics
The latest Housing Market Analyst report from Capital Economics – the most bearish of housing market commentators - predicts that house prices have a further 20 per cent to fall.
However, they expect most of this decline to occur in the first half of this year. Thereafter prices will fall by a further five per cent beyond "fair value" as low interest rates and more affordable property encourages greater activity.
The market, they add, should stabilise in early 2010, by which point the average value of a property in the UK will have fallen by 35 per cent from peak to trough.
Transaction Levels Will Improve
Although new buyer enquiries have started to creep up recently, implying that mortgage approvals could also begin to increase, Capital Economics think that any rise in market activity this year will be modest.
They predict 750,000 transactions in 2009, up from 630,000 last year but almost 40 per cent less than 2007.
Demand, they say, will be constrained as lenders continue to keep a tight hold on lending, particularly in the face of a deteriorating economic outlook.
The report even suggests that borrowers' priorities may shift from taking out new mortgages to paying off more of their existing debt; if this is the case, it says, net mortgage lending could turn negative this year.
Affordability Improving
For those who do have money to hand, the good news is that property is becoming much more affordable.
The report notes that affordability levels are now roughly in line with their long-term average.
However, the downside is that "tightened lending criteria and fewer potential homeowners have rendered this improvement largely irrelevant".
Even with the likely prospect of more interest rate reductions to come, Capital Economics believe that mortgage demand will remain low as lenders will be wary of passing on the full cuts against the poor economic outlook.
While they forecast that the Base Rate will drop to zero per cent, they anticipate that mortgage rates for new borrowers will only come down to three per cent per cent.
The report concludes: "While the deteriorating economic outlook increases the downside risks, if official interest rates fall to zero as we expect, that could support house prices and prevent them undershooting fair value by as much as in past downturns."
However, they expect most of this decline to occur in the first half of this year. Thereafter prices will fall by a further five per cent beyond "fair value" as low interest rates and more affordable property encourages greater activity.
The market, they add, should stabilise in early 2010, by which point the average value of a property in the UK will have fallen by 35 per cent from peak to trough.
Transaction Levels Will Improve
Although new buyer enquiries have started to creep up recently, implying that mortgage approvals could also begin to increase, Capital Economics think that any rise in market activity this year will be modest.
They predict 750,000 transactions in 2009, up from 630,000 last year but almost 40 per cent less than 2007.
Demand, they say, will be constrained as lenders continue to keep a tight hold on lending, particularly in the face of a deteriorating economic outlook.
The report even suggests that borrowers' priorities may shift from taking out new mortgages to paying off more of their existing debt; if this is the case, it says, net mortgage lending could turn negative this year.
Affordability Improving
For those who do have money to hand, the good news is that property is becoming much more affordable.
The report notes that affordability levels are now roughly in line with their long-term average.
However, the downside is that "tightened lending criteria and fewer potential homeowners have rendered this improvement largely irrelevant".
Even with the likely prospect of more interest rate reductions to come, Capital Economics believe that mortgage demand will remain low as lenders will be wary of passing on the full cuts against the poor economic outlook.
While they forecast that the Base Rate will drop to zero per cent, they anticipate that mortgage rates for new borrowers will only come down to three per cent per cent.
The report concludes: "While the deteriorating economic outlook increases the downside risks, if official interest rates fall to zero as we expect, that could support house prices and prevent them undershooting fair value by as much as in past downturns."
Economic capital and Basel II
Basel II introduces a three-pillar concept that seeks to align regulatory requirements with economical principles of risk management. Its capital requirements have wide-ranging implications for risk management and, thus, for corporate governance. Basel II compliance is a risk management challenge with strategic business implications rather than a pure technical issue. KPMG professionals can help cope with these new challenges.
Regulatory capital planning has always been an important aspect of banks’ compliance activities. Now, however, economic capital planning is becoming increasingly important to banks’ overall competitiveness-and with the development of the Basel II proposals for a new capital accord, understanding and measuring economic capital has also become a compliance obligation.
“Economic capital” is the capital banks set aside as a buffer against potential losses inherent in any business activity-corporate lending, for example, or currency trading. Banks’ focus on economic capital is part of an industry-wide movement to measure risks, to optimize performance measurement, to base strategic decisions on accurate information, and thus to strengthen an institution’s long-term profitability and competitiveness.
In evaluating these issues, leaders are considering questions including:
* Do we understand the nature and level of risk the bank is taking?
* How much capital is needed to support the bank’s total risk? What is the expected return on that capital?
* Is the bank over or under capitalized in relation to its risks?
* Are individual business lines creating or destroying shareholder value?
* What are the major sources of concentration and diversification on our portfolio? What opportunities for growth or diversification exist within the bank?
* How should the business’s capital be managed within constraints imposed by regulators, investors, and rating agencies?
* How do we improve our portfolio performance? Which exposures should we buy or sell and in what quantities? What is an optimal strategy for hedging/selling down risk?
* Do we need better analytics to support our discussions with rating agencies and thereby support our rating?
Although economic capital planning has been evolving for a number of years, it has attained new focus and urgency as a result of the regulatory mandates of the Basel II Capital Accord (Basel II). In a new three-pillar framework, Basel II introduces the concept of economic capital into the regulatory capital consideration by requiring banks to determine capital adequacy based on the level of risk posed by specific business activities. In emphasizing capital planning overall, Basel II overcomes a substantial shortcoming of its 1988 predecessor, which did not require banks to develop their own methods, processes, and systems to measure the capital level adequate for the risks they assume.
This white paper emphasizes the importance of banks’ evolving efforts to integrate economic capital planning into overall risk management. These efforts can help banks build value in their businesses as well as comply with Basel II.
Regulatory capital planning has always been an important aspect of banks’ compliance activities. Now, however, economic capital planning is becoming increasingly important to banks’ overall competitiveness-and with the development of the Basel II proposals for a new capital accord, understanding and measuring economic capital has also become a compliance obligation.
“Economic capital” is the capital banks set aside as a buffer against potential losses inherent in any business activity-corporate lending, for example, or currency trading. Banks’ focus on economic capital is part of an industry-wide movement to measure risks, to optimize performance measurement, to base strategic decisions on accurate information, and thus to strengthen an institution’s long-term profitability and competitiveness.
In evaluating these issues, leaders are considering questions including:
* Do we understand the nature and level of risk the bank is taking?
* How much capital is needed to support the bank’s total risk? What is the expected return on that capital?
* Is the bank over or under capitalized in relation to its risks?
* Are individual business lines creating or destroying shareholder value?
* What are the major sources of concentration and diversification on our portfolio? What opportunities for growth or diversification exist within the bank?
* How should the business’s capital be managed within constraints imposed by regulators, investors, and rating agencies?
* How do we improve our portfolio performance? Which exposures should we buy or sell and in what quantities? What is an optimal strategy for hedging/selling down risk?
* Do we need better analytics to support our discussions with rating agencies and thereby support our rating?
Although economic capital planning has been evolving for a number of years, it has attained new focus and urgency as a result of the regulatory mandates of the Basel II Capital Accord (Basel II). In a new three-pillar framework, Basel II introduces the concept of economic capital into the regulatory capital consideration by requiring banks to determine capital adequacy based on the level of risk posed by specific business activities. In emphasizing capital planning overall, Basel II overcomes a substantial shortcoming of its 1988 predecessor, which did not require banks to develop their own methods, processes, and systems to measure the capital level adequate for the risks they assume.
This white paper emphasizes the importance of banks’ evolving efforts to integrate economic capital planning into overall risk management. These efforts can help banks build value in their businesses as well as comply with Basel II.
Fermat Enterprise Risk Management Suite
Fermat Enterprise Risk Management Suite provides integrated risk and performance management for the global financial services industry. The award-winning products address enterprise-wide internal and regulatory requirements and assist financial institutions to reduce risk and maximize returns in their daily business decisions.
Global banks use Fermat Enterprise Risk Management software solutions such as Basel II, Economic Capital and Limit Monitoring, to comply with demanding regulatory standards in their countries and optimize their risk and performance management practices.
Global banks use Fermat Enterprise Risk Management software solutions such as Basel II, Economic Capital and Limit Monitoring, to comply with demanding regulatory standards in their countries and optimize their risk and performance management practices.
* Targeted, scalable solutions addressing real and pressing customers' need
* Modular, building block solution architecture reducing barriers to adoption and enabling banks a validated step-by-step deployment approach
* A simplified integration and evolution that builds upon previous investments
* Respect of delivery commitments: we deliver on time as testified by our track record
* Well-defined market focus and strong customer references supporting a capital-efficient growth momentum
* Strong intellectual property and highly educated, diverse human capital
* Commercial leverage of successful technology, channel and delivery partnerships
* Modular, building block solution architecture reducing barriers to adoption and enabling banks a validated step-by-step deployment approach
* A simplified integration and evolution that builds upon previous investments
* Respect of delivery commitments: we deliver on time as testified by our track record
* Well-defined market focus and strong customer references supporting a capital-efficient growth momentum
* Strong intellectual property and highly educated, diverse human capital
* Commercial leverage of successful technology, channel and delivery partnerships
Truly Integrated
Based on a robust and flexible architecture, the Fermat product range has been designed from scratch by financial engineers and software developers combining extensive academic and professional knowledge in finance, mathematics and information technology.
All software packages have been built on a shared and fully integrated infrastructure, the Fermat DataMart (FDM), which is the cornerstone of our modular product line. All modules benefit from the same data model and the Fermat DataMart has a strong focus on performance and handling large volumes of data. As a consequence, Fermat Enterprise Risk Management Suite enables financial institutions to operate on a truly consistent software solution within a shared functional dataflow and a single workflow.
Product Features
Economic capital by risk type
We have developed ‘economic capital’ as a consistent and comparable measure of risk across all risk types and geographies at Fortis. It serves as an indicator of Value at Risk (VaR) to a confidence interval of 99.97% and with a horizon of one year, which represents extreme events. The methodology is refined and improved on an ongoing basis.
The economic capital is calculated separately for each risk type per business. We then determine the total economic capital at business level, at banking/insurance level and for Fortis as a whole. The figures obtained in this way are used for a range of internal monitoring and management purposes.
Since it is extremely unlikely that all risks will become reality at the same moment, an allowance is made for diversification benefits when adding up the individual risks. The result is a total economic capital figure at company level that is significantly lower than the sum of the individual risks.
In addition to this more general diversification, Fortis benefits from a netting effect across bank and insurance interest-rate risk due to the fundamental balance sheet differences between our banking and our insurance operations.
Breakdown
The graph represents the contribution of each risk to our total diversified economic capital. Consequently, risks such as ‘insurance risk’ contribute very little to the overall amount because they only correlate weakly with the other risks.
WHAT IS SUSTAINABILITY?
Long Version:
Sustainability relates to the relationships between economic, social, institutional and environmental aspects of human existence. It organizes decisions to allow for current economic needs to be met while preserving bio diversities and ecosystems to maintain the same quality of life for future generations. Sustainability calls for humans (as civic creatures):
* Respect and care for the community
* Improve the quality of life
* Conserve Earth’s vitality and diversity
* Minimize the depletion of non-renewable resources
* Change attitudes and practices to keep within the planet’s carrying capacity
Oxford English Dictionary Definition
Sus.tain.a.ble adjective
1. of relating to, or designating forms of human economic activity and culture that do not lead to environmental degradation, esp. avoiding the long term depletion of natural resources.
2. Utilization and development of natural resources in ways which are comparative with the maintenance of these resources and with the conservation of the environment for the future generations.
Sustainability relates to the relationships between economic, social, institutional and environmental aspects of human existence. It organizes decisions to allow for current economic needs to be met while preserving bio diversities and ecosystems to maintain the same quality of life for future generations. Sustainability calls for humans (as civic creatures):
* Respect and care for the community
* Improve the quality of life
* Conserve Earth’s vitality and diversity
* Minimize the depletion of non-renewable resources
* Change attitudes and practices to keep within the planet’s carrying capacity
Oxford English Dictionary Definition
Sus.tain.a.ble adjective
1. of relating to, or designating forms of human economic activity and culture that do not lead to environmental degradation, esp. avoiding the long term depletion of natural resources.
2. Utilization and development of natural resources in ways which are comparative with the maintenance of these resources and with the conservation of the environment for the future generations.
Insurance Companies & IRDA’s 'Economic Capital' Norms
IRDA, the Insurance Regulatory Development Authority has asked insurers to initiate the process of calculating ‘economic capital’ from March 2010. This step is a move to catalyze the lower capital requirement for life insurers,
Economic capital is calculated by determining the amount of capital that insurers need to ensure. This is a step towards risk-based capital. IRDA will review it at the end of October.
Though at the moment, most of the insurers are doing the theoretical calculation. But according to the current norms, insurers have to give the actuarial calculation of solvency.
The calculation is variable and depending on the composition of the product. If a product has guaranteed return, the capital requirement would be higher, whereas for products where there was no guarantee, the capital requirement would be lower.
“If you look to the present product composition, every insurance company will have to keep aside capital based on the solvency margin,” said Niraj Jain, the Chief Principal Officer, InsuranceMall.
Right now, the insurance companies are following a formula-based method of calculating capital which includes solvency margin (varies with different products.) It is higher for the products which have higher guarantees but it’s lower for ULIPs.
Now, if you want to understand the nuances of different types of policies and its price, feel free to seek the help of InsuranceMall to select the right products based on your need.
Economic capital is calculated by determining the amount of capital that insurers need to ensure. This is a step towards risk-based capital. IRDA will review it at the end of October.
Though at the moment, most of the insurers are doing the theoretical calculation. But according to the current norms, insurers have to give the actuarial calculation of solvency.
The calculation is variable and depending on the composition of the product. If a product has guaranteed return, the capital requirement would be higher, whereas for products where there was no guarantee, the capital requirement would be lower.
“If you look to the present product composition, every insurance company will have to keep aside capital based on the solvency margin,” said Niraj Jain, the Chief Principal Officer, InsuranceMall.
Right now, the insurance companies are following a formula-based method of calculating capital which includes solvency margin (varies with different products.) It is higher for the products which have higher guarantees but it’s lower for ULIPs.
Now, if you want to understand the nuances of different types of policies and its price, feel free to seek the help of InsuranceMall to select the right products based on your need.
Capital Economics: Bulgaria Will Ask for IMF Loan
Bulgaria is most likely to soon ask for an IMF loan following its neighbor Romania, according to a report by UK based Capital Economics Ltd..
Bulgaria will ask for the International Monetary Fund (IMF) loan after a collapse of exports and investment in the country, Capital Economics stated, cited by Bloomberg.
They went on to say that Bulgaria's economy is expected to shrink 5 percent this year, forcing the government to drain its fiscal reserves to restore liquidity. The report added that reserves will only cover such needs for six to 12 months.
The report added that many other Eastern European countries have more worries in their economies than Bulgaria.
The Baltic nations of Latvia and Lithuania will show the biggest decline at 15 percent, the London-based research firm forecast. Hungary, which needed an International Monetary Fund-led bailout last year, and Romania, which is negotiating external aid, will both shrink 7,5 percent, the research company concluded.
Editorials | Interviews | News analysis Economic Capital in the light of Basel II 2nd pillar requirements
Established by the Bank for International Settlement through the Basel committee on banking supervision, Basel II 2nd Pillar directives on Supervisory Review were designed primarily to make sure that banks estimate their equity needs as accurately as possible, taking into account their risk profile.
Within this regulatory context, the Economic Capital approach is a key element to enable banks to efficiently deal with profitability and solvability constraints, allowing banks to meet 2nd pillar requirements while keeping their specificities.
1. The concepts behind regulatory capital, economic capital and internal capital
The regulatory capital:
The regulatory capital is defined by regulators and sets bank’s minimum amount of equity. The calculation modalities are defined within Basel 2 framework. They are based, for IRBA, on two main data: the probability of default of the counterparty (PD) and the loss given default (LGD).
The economic capital:
The economic capital defines bank’s amount of equity required to cover a maximum potential loss at a defined confidence level for a given time horizon.
It is calculated by the bank using an internal model and allows to improve the equity allocation to the business lines by providing a finer estimate with more granularity.
Within this regulatory context, the Economic Capital approach is a key element to enable banks to efficiently deal with profitability and solvability constraints, allowing banks to meet 2nd pillar requirements while keeping their specificities.
1. The concepts behind regulatory capital, economic capital and internal capital
The regulatory capital:
The regulatory capital is defined by regulators and sets bank’s minimum amount of equity. The calculation modalities are defined within Basel 2 framework. They are based, for IRBA, on two main data: the probability of default of the counterparty (PD) and the loss given default (LGD).
The economic capital:
The economic capital defines bank’s amount of equity required to cover a maximum potential loss at a defined confidence level for a given time horizon.
It is calculated by the bank using an internal model and allows to improve the equity allocation to the business lines by providing a finer estimate with more granularity.
Figure 1: Economic capital representation
The economic capital aims only at covering exceptional losses. Expected losses should be covered by provisions, while extreme losses are not covered under this approach.
The internal capital:
The internal capital corresponds to the equity amount required to cover all risks identified by the bank. Its calculation is based on internal methods developed by each institution, taking into account its own specificities.
Internal capital differs from economic capital on two points:
* The finality of economic capital calculation is to evaluate risks incurred as close as possible to their economic reality with sophisticated models offering a fine granularity; while the internal capital is limited to a more generic evaluation of the risks using more global and approximate methods.
* Furthermore, the internal capital should be validated by ICAAP, but not the economic capital.
For reminder, ICAAP (Internal Capital Adequacy Assessment Process) is a regulatory procedure which determines if the equities are sufficient to cover all the risks faced the financial institution. The ICAAP validation by local regulator is a mandatory step in the bank’s Basel II certification process.
ICAAP must describe calculation and stress tests procedures for different risks encountered by the bank. The main risks which must be guided by ICAAP are:
* Credit Risk
* Market Risk
* Operational Risk
* Liquidity Risk
* Concentration Risk
* Residual Risk
* Securitization Risk
* Business Risk
* Structural interest rate Risk
The treatments relative to all identified risk types must be describe under ICAAP. The procedure must predict stress tests, minima, in the following situations:
* An interest rate rise or a drop of 200 base points
* A real estate drop of 30%
2. Reminder on 2nd Pillar fundamentals
The 2nd Pillar formalizes the principles of risk management governance. It allows banks to estimate at best their equity adequacy with their risk profiles. The approach is articulated around 3 axis:
* Optimize risks managed under 1st pillar.
* Integrate macro-economic variables and cyclical effects.
* Address risks not managed by 1st pillar.
3. The economic capital approach a tool to meet 2nd Pillar requirements
The economic capital approach allows to cover unexpected losses (exceptional losses), for all risks types managed by the bank’s risk department, even the ones not taken into account by 1st pillar. These risks should be integrated into regulatory capital calculations in order to meet 2nd pillar requirements.
From a calculation perspective, the economic capital is different from the result of a sum of elementary risks; it deals with the correlation between different assets, which allows to reduce the global cost of risk’s of a bank providing that it has a portfolio diversified enough as depicted on the figure below.
The internal capital:
The internal capital corresponds to the equity amount required to cover all risks identified by the bank. Its calculation is based on internal methods developed by each institution, taking into account its own specificities.
Internal capital differs from economic capital on two points:
* The finality of economic capital calculation is to evaluate risks incurred as close as possible to their economic reality with sophisticated models offering a fine granularity; while the internal capital is limited to a more generic evaluation of the risks using more global and approximate methods.
* Furthermore, the internal capital should be validated by ICAAP, but not the economic capital.
For reminder, ICAAP (Internal Capital Adequacy Assessment Process) is a regulatory procedure which determines if the equities are sufficient to cover all the risks faced the financial institution. The ICAAP validation by local regulator is a mandatory step in the bank’s Basel II certification process.
ICAAP must describe calculation and stress tests procedures for different risks encountered by the bank. The main risks which must be guided by ICAAP are:
* Credit Risk
* Market Risk
* Operational Risk
* Liquidity Risk
* Concentration Risk
* Residual Risk
* Securitization Risk
* Business Risk
* Structural interest rate Risk
The treatments relative to all identified risk types must be describe under ICAAP. The procedure must predict stress tests, minima, in the following situations:
* An interest rate rise or a drop of 200 base points
* A real estate drop of 30%
2. Reminder on 2nd Pillar fundamentals
The 2nd Pillar formalizes the principles of risk management governance. It allows banks to estimate at best their equity adequacy with their risk profiles. The approach is articulated around 3 axis:
* Optimize risks managed under 1st pillar.
* Integrate macro-economic variables and cyclical effects.
* Address risks not managed by 1st pillar.
3. The economic capital approach a tool to meet 2nd Pillar requirements
The economic capital approach allows to cover unexpected losses (exceptional losses), for all risks types managed by the bank’s risk department, even the ones not taken into account by 1st pillar. These risks should be integrated into regulatory capital calculations in order to meet 2nd pillar requirements.
From a calculation perspective, the economic capital is different from the result of a sum of elementary risks; it deals with the correlation between different assets, which allows to reduce the global cost of risk’s of a bank providing that it has a portfolio diversified enough as depicted on the figure below.
Figure 2: Risks considered under each model
4. Advantages of Economic Capital regarding the 2nd pillar
The economic capital approach is based on the evaluation of different scenarios to measure the exposition of the bank in terms of losses. The selected scenarios take into account the projected evolution of several macro-economic indicators and also cyclical conjectural effects. Finally, an expected probability is attributed to each scenario to help weight their relative importance.
The modelization of these scenarios using the “Monte Carlo” statistical method will produce the curve depicted above in Figure 1. It is then the role of the bank’s management to define the confidence level acceptable to cover exceptional losses in line with the risk appetite and the mission statement defined for the bank.
Although the economic capital approach is not mandatory, it can be used to improve the risk measure supported by a financial institution; the increased sophistication of the risk management framework being offset by the potential reduction of the cost of risk and, more importantly, by a better mastery of the risks incurred by the financial institution. It will also ease the financial institution to meet ICAAP’s regulatory requirements which include the evaluation of macro-economic indicators and cyclical conjectural effects.
The interest in the approach resides also in the fact that it is applicable to risks not taken into account in Basel II 1st pillar. As the banks willing to complete Basel II certification must then integrate these risks in their risk management framework, be it in an approximate way in the internal capital calculation. They should also carefully consider the true advantages brought by the Economic Capital approach to meet these regulatory requirements, especially in the light of the expected Basel III framework.
The modelization of these scenarios using the “Monte Carlo” statistical method will produce the curve depicted above in Figure 1. It is then the role of the bank’s management to define the confidence level acceptable to cover exceptional losses in line with the risk appetite and the mission statement defined for the bank.
Although the economic capital approach is not mandatory, it can be used to improve the risk measure supported by a financial institution; the increased sophistication of the risk management framework being offset by the potential reduction of the cost of risk and, more importantly, by a better mastery of the risks incurred by the financial institution. It will also ease the financial institution to meet ICAAP’s regulatory requirements which include the evaluation of macro-economic indicators and cyclical conjectural effects.
The interest in the approach resides also in the fact that it is applicable to risks not taken into account in Basel II 1st pillar. As the banks willing to complete Basel II certification must then integrate these risks in their risk management framework, be it in an approximate way in the internal capital calculation. They should also carefully consider the true advantages brought by the Economic Capital approach to meet these regulatory requirements, especially in the light of the expected Basel III framework.
Figure 3: Economic capital as answer to Basel II 2nd pillar requirements
5. Conclusion
The setup of the Economic Capital approach is not required to comply with regulatory authorities as such. However both ICAAP and Basel II 2nd pillar requirements prompt for the use of more comprehensive and sophisticated tools for risk management and, in any case, several topics have to be addressed in order to insure full compliance with the requirements.
The Economic Capital approach is a powerful tool, allowing to meet these requirements and offering a comprehensive solution, foundation of a global and integrated approach for risk management. Furthermore, the Economic Capital presents a real opportunity for financial institutions to optimize their equity allocation by business line, to refine their risks evaluation, understand better the risks they are facing and, ulimatly, to reduce their global risk’s cost.
The Economic Capital approach is a powerful tool, allowing to meet these requirements and offering a comprehensive solution, foundation of a global and integrated approach for risk management. Furthermore, the Economic Capital presents a real opportunity for financial institutions to optimize their equity allocation by business line, to refine their risks evaluation, understand better the risks they are facing and, ulimatly, to reduce their global risk’s cost.
Discovery of Morocco
So many people! Our first stop was Casablanca, the economic capital of Morocco, a city of 3.5 million people. Here, we encountered the traffic, the noise, and the perpetual motion of busy lives.
And here also, we were fortunate to experience the legendary hospitality of the Moroccans. Abdellah did not know me when I sent him an email, but he replied immediately with his phone number and an invitation to call when I got to Casa. An hour after I called he was at our hotel, dressed in his warmest jellaba against the chill of the evening, and ready to show us the sights of his city. After driving us around, he invited us to his home for tea and coffee. Here, we met his wife and children, saw how the average Moroccan lives, and spent an hour satisfying our curiosity about their daily lives. Their warm hospitality to total strangers gave us a wonderful welcome to the country that put us in a relaxed state of mind for the next two weeks of exploration and discovery.
And here also, we were fortunate to experience the legendary hospitality of the Moroccans. Abdellah did not know me when I sent him an email, but he replied immediately with his phone number and an invitation to call when I got to Casa. An hour after I called he was at our hotel, dressed in his warmest jellaba against the chill of the evening, and ready to show us the sights of his city. After driving us around, he invited us to his home for tea and coffee. Here, we met his wife and children, saw how the average Moroccan lives, and spent an hour satisfying our curiosity about their daily lives. Their warm hospitality to total strangers gave us a wonderful welcome to the country that put us in a relaxed state of mind for the next two weeks of exploration and discovery.
We saw two completely different faces of the Moroccan people. In the medinas and the cities, the pace was hectic, harried and hassled. But just outside the gates, we encountered tranquil souls, apparently passing the time in quiet reflection, appreciating the moments of the day. Even inside the medinas, the mosques and medersas were havens of stillness against the currents of the moving crowds.
We were prepared for some bargaining. Fixed prices are not part of the Moroccan way of doing business. But the extent to which every purchase must be negotiated is amazing. Inevitably, the participant with the best knowledge of the item's value, and the most time to spare, comes out the winner. Unique handicrafts picked up at roadside stands for one-quarter the asking price were inevitably available in the hotel shops for half of what we paid. I guess the difference is what you pay for the street theatre, the entertaining acts vendors put on to make you buy.
We were prepared for some bargaining. Fixed prices are not part of the Moroccan way of doing business. But the extent to which every purchase must be negotiated is amazing. Inevitably, the participant with the best knowledge of the item's value, and the most time to spare, comes out the winner. Unique handicrafts picked up at roadside stands for one-quarter the asking price were inevitably available in the hotel shops for half of what we paid. I guess the difference is what you pay for the street theatre, the entertaining acts vendors put on to make you buy.
Wandering past Place Mohammed V in Casablanca, we encountered a crowd of people in colourful dress carrying bendirs and darbukas (drums), andirs (trumpets), guimbris and kanzas (strings). The dozen different groups distributed themselves around the fountain. After a lengthy preparation involving warming the bendirs over charcoal braziers, the entertainment began. Mock swordfights, dances, chanting, the beating of drums, a feast for the eyes and ears. The rhythms told us that we were indeed in Africa. There was rarely a day when we didn't encounter music and dance.
The spirit of free enterprise. We turned a corner in the Fes medina, and there was this boy, sitting backwards on a donkey. This was definitely a photo opportunity! And a money-making opportunity for the boy. He asked (and received) five dirhams for the photo.
We had been warned that many Moroccans do not like to have their picture taken. Indeed, groups of women would hide or wave us off if a camera was pointed even vaguely in their direction. On the other hand, people in picturesque situations were quick to demand payment for the use of their image.
There were children everywhere. We should not have been surprised, more than 50% of Morocco's 30 million are under 20. Some were shy and avoided our glances, but most were eager to run up and greet us, "bonjour monsieur, bonjour madame", and they would gaze up with their big brown eyes. And then they would demand "un dirham".
Sociology of Pierre Bourdieu 1930-2002
The background of Pierre Bourdieu is a departure from Marxism and coming closer to Weber. He was still a radical. Class dominance gets challenged at the superstructure level, therefore not directly on economic class interests but at the level of the cultural. As with Weber, social ideas generate their own partial autonomy. People have class interests but those with the most capital surpluses can trade them in for symbolic capital in order to buy future power or tying others in now.
Economic capital is equities and surpluses in high business salaries; social capital is high among the communicating networking of high social status people; cultural capital is in educational degrees and socially considered aesthetic quality; and symbolic capital is a form of honour and loyalty. These capitals can have their own surpluses, their own storage as if in some imaginary bank (as well as real banking for the economic) and can be traded.
Whilst he drew on Levi-Strauss' structuralist anthropology for objective structure, he found it dead to action and agency (like an individual social actor), unlike with his use of subjective existentialism. So he wanted the two combined, where people acted (more than just following structural rules) within a received objective world.
Bordieau was moving beyond the celebrated continental structuralism before Giddens' structuration theory and Bhaskar's transformational model of social action, both of which also tried to break the division between subjectivism and objectivism, using both Wittgenstein and phenomenology, and seeing strutures as enabling as well as constraining.
Actors do not engage in the precision of rational choice theory; they do still set out to maximise returns for themselves and their own in a utilitarian fashion. People might not make rational choices as if they are rational agents, but they do operate skilfully and practically according to the shared understanding they receive in specialities. In this Bourdieu draws upon social phenomenology, Heidegger and the later Wittgenstein as well as Goffman. It is not acting according to explicitly known theory, nor is it always conscious. The taken-for-granted mental world prior that leads directly to a good overall feel for it and acting according to the practical knowledge therein is called Doxa. This echoes views of Peter Berger and what constitutes the sociology of knowledge. Doxa is also like a deep paradigm. Heresiarchs can crack any one doxa: they might be a group within a high social status ruling class with plenty of cultural capital but little economic capital, like the poor, heroic, serious artist.
The basis of how symbolic capital works was Marcel Mauss' work The Gift, so that the symbolic exchange that takes place has a binding effect. Honour and loyalties get bound together within social systems of exchange. For Bourdieu, economic capital is converted into symbolic capital in order to gain sufficient obligation back and create relationships of dependence from lower social classes. Also economic capital can be deferred via symbolic capital, for example in purchasing education for one's own offspring which costs money but is rewarded by reproducing the family in high status positions. Cultural capital works via superior aesthetic taste, and that taste relates to social position: actual preferences relate to social status. These different categories of capital emphasise that (like for Marx) capital is a form of social relation.
This receiving and social acting begins in childhood, with dispositions of perception, thought and actions towards practices, improvisations, attitudes or bodily movements, and dispositions combine to generate habitus of a practical sense of the world by which all sorts of action strategies can be generated.
Just as Wittgenstein had different language games so Bourdieu understands the divisions of more practical knowledge into fields. Dispositions then are effectively socialisation and habitus is having gained the social world of that field into one's mental make-up. Dispositions are adjusted by the continuing constraints of the social world actually inhabited, including those constraints specific to social status. Thus the combining into a habitus is affected too, and therefore action back into that social world.
The work of Basil Bernstein is relevant here. His suggesting once strong contextualised transmission of middle class values and later weaker transmission of values based on work orientation, comes into this understanding of dispositions; then also comes habitus and having a whole grasp of dispositions among middle class members and therefore the strategies of speaking in elaborate and restrictive codes that give advantage to the middle class. (Care is needed here with a terminology clash: Bourdieu's use of restricted is for high cultural value art whereas expanded is mass art that does not require specialist decoding).
People therefore become acclimatised, skilled operators in their social fields rather like a person drives a car. Most of the time it seems semi-conscious once learned, and social status and power reproduces itself.
The inflexibility of dispositions and durability of each habitus do not account for change so well. So this approach is good for suggesting how things reproduce and stay the same, but not so good for explaining change.
Bourdieu is useful for considering always that the economy is also a symbolic and cultural activity, and utiility lies in these. In terms of consumption it is of course all about taste (utility is ultimately a psychological term of satisfaction in rational choice economic theory), and his postmodern notion is that aesthetics are determined by social position and do not have Kantian independence. Taste is collective. In terms of production those who avoid the mass market can earn the cultural capital of insiders' approval and this can be traded for economic capital with some loss of status (a good example could be how Jack Vettriano sells a lot of his paintings but is regarded as having low cultural capital among artists). Avant garde art is at first seemingly opposed to the economy of commercial production (as in art is sacred and "consecrated" whereas volume production is profane) - until of course the cultural production of this art is recognised as having its own logic of a higher value higher risk economy than the pumping out of prints and popular styles with a clearly more mass economic objective. Who buys cultural value art? Once again it is people of high status who can defer their economic capital into symbolic capital, and who demonstrate their social status derived aesthetic value. Some art is bound to be more economic and popular: cinema, photography and jazz could never return enough cultural capital. Bourdieu about television spoke of "cultural fast food"
Bourdieu has a methodological impact. Theory has to be grounded in research. He did not agree with sociological models that paid little attention to actual empirical realities. Distinction: A Social Critique of the Judgment of Taste was empirical study of taste within social classes and looking at the uneven distributions of aesthetic dispositions. Such capital upholds social authority. He showed social dominance in research findings (especially in education) and how superiority was shown in a process of symbolic reproduction among the socially favoured with a beneficial habitus for them (over working class habitus) generating better strategies. His study of his own locality of peasants in Béarn and why some did not marry was historical as much as sociological.
Bourdieu introduces the notion of participant objectivation. The area of research is an objective world of the habitus. It is important also in this processes to get inside people's motives for actions - their own skills and abilities in acting. Thus objective and subjective are combined. Furthermore, the researcher is not an all seeing objective eye, but should be self-critical in one's own presuppositions. This approach is called doing reflexive sociology.
There are a number of criticisms to consider.
First of all it is quite possible to have high cultural capital surpluses and high economic capital surpluses. The works of Jane Austen have not lost their high cultural capital simply because they sell alot. Nor do great works of art have to sell for less because people buy endless books or posters with them on show. Also categories of art vary internally in their cultural capital: there are art versions of cinema, photography and jazz. Of course Bourdieu discusses a rarified community keeping up its social role by producing academically interpreted artwork. It may be, though, that the dynamics of the art market are purely to uphold savings: that a class of people trade in money-absorbing artworks of no particular value other than in their money-holding role. A widespread view that some art is "just crap" must diminish their cultural value, as with the Turner Prize and the constant need to defend it, but these artworks continue to trade and be emblems of wealth, and carry on demanding high prices for passing between the wealthy and institutions.
Secondly there seems to be some overlap in symbolic and cultural capital. If cultural capital is socially derived then its task is to uphold social status and is a purchase. Visits to the opera have this social role, in the UK, via high seat prices and so some people identify with it. Culture is symbolic anyway, and art joins music in being less precise symbolic forms of expression than words. Education is more than investment in forms of reproducing honour, but is an investment into the cultures of words and skills with presentation strategies that translate into social and economic gain. Presumably networking is a social capital to be transferred into other forms of capital, and is akin to being in a profession, meant in broad sociological terms of a restricted membership of people where members approve new recruits according to its ethos that may involve training and socialisation into it (thus including, sociologically, a "profession" of artists). Professions, of course, set up scarcity and therefore high fees (whatever the ethics of the product being purchased, including that of profession-regulated, service-based, honest advice). Allowing for this kudos of association, I would suggest three forms of capital - economic, social and symbolic, the latter including the cultural.
Thirdly there is some lack of clarity about the terms doxa, dispositions and habitus, and quite when fields are employed or something more total and holistic is being discussed, and one wonders whether there is a need for all these terms at all. Dispositions have a kind of cod-psychology about them; both dispositions and habitus are the process of socialisation and the separation of these seems more analytical than real. The objective-subjective combination is that we have society in our individual heads and that we remain individuals in society with some freedom to act creatively. Furthermore if doxa is a deep paradagm (deeper than Kuhn's understanding) then habitus is a merging of doxa and habitus - society in the individual mind. Once we have dispositions, are we not then socialised into the doxa as we achieve habitus? The habitus is then waiting for us to, well, inhabit it. So perhaps just two terms could suffice - fields and habitus. Nor do we always intend to act in some utilitarian manner by increasing stocks of different forms of capital, and arguably some forms of capital as described are not utilitarian. The material-spiritual exchange that Marcel Mauss discusses might be called utilitarian at one level, but given the material-spiritual difference it might be called sacrificial or even tribal.
Bourdieu represents an approach to cultural theory, grounded in the empirical and what groups of people do, to be discovered by participant objectivation (why not participant observant objectification?). He tries to set this out logically through use of plenty of terminology. Well, here is the reflexive part: he is trying to acquire symbolic (including cultural) capital of the sociologists with whom he networked, by using his own rarified analytical terminilogy for their academic approval, when it might be a lot simpler and presentable to more people. It might sell a few more books if it did become clearer, and it might be more coherent and therefore increase both its economic and symbolic capital.
Pierre Bourdieu was born 1 August 1930 in the Béarn area of France. He died January 23 2002 from cancer. He studied Philosophy at the École Normale Supérieure under Louis Althusser and was a schoolteacher at Moulins between 1955 and 1956. Then for two years he was conscripted into the military in Algeria and wrote Sociologie d'Algérie, the Algerians, published in 1958, as a result - looking at the Berbers under colonialism and seeing what their original kinship structres were. These structures were at variance from social action, and so structure and action needed to be combined. He went on to teach at the University of Algiers to 1960 and on to universities at Paris and Lille up to 1964. A longer job was from 1964-1981 as Director of Studies at École Pratique des Hautes Études as well as being Director of the Centre de Sociologie Européen from 1968 and becoming Professor of Sociology at the Collège de France in 1981. Bourdieu was anti-globalisation and fought against neo-liberal dominance.
Economic capital is equities and surpluses in high business salaries; social capital is high among the communicating networking of high social status people; cultural capital is in educational degrees and socially considered aesthetic quality; and symbolic capital is a form of honour and loyalty. These capitals can have their own surpluses, their own storage as if in some imaginary bank (as well as real banking for the economic) and can be traded.
Whilst he drew on Levi-Strauss' structuralist anthropology for objective structure, he found it dead to action and agency (like an individual social actor), unlike with his use of subjective existentialism. So he wanted the two combined, where people acted (more than just following structural rules) within a received objective world.
Bordieau was moving beyond the celebrated continental structuralism before Giddens' structuration theory and Bhaskar's transformational model of social action, both of which also tried to break the division between subjectivism and objectivism, using both Wittgenstein and phenomenology, and seeing strutures as enabling as well as constraining.
Actors do not engage in the precision of rational choice theory; they do still set out to maximise returns for themselves and their own in a utilitarian fashion. People might not make rational choices as if they are rational agents, but they do operate skilfully and practically according to the shared understanding they receive in specialities. In this Bourdieu draws upon social phenomenology, Heidegger and the later Wittgenstein as well as Goffman. It is not acting according to explicitly known theory, nor is it always conscious. The taken-for-granted mental world prior that leads directly to a good overall feel for it and acting according to the practical knowledge therein is called Doxa. This echoes views of Peter Berger and what constitutes the sociology of knowledge. Doxa is also like a deep paradigm. Heresiarchs can crack any one doxa: they might be a group within a high social status ruling class with plenty of cultural capital but little economic capital, like the poor, heroic, serious artist.
The basis of how symbolic capital works was Marcel Mauss' work The Gift, so that the symbolic exchange that takes place has a binding effect. Honour and loyalties get bound together within social systems of exchange. For Bourdieu, economic capital is converted into symbolic capital in order to gain sufficient obligation back and create relationships of dependence from lower social classes. Also economic capital can be deferred via symbolic capital, for example in purchasing education for one's own offspring which costs money but is rewarded by reproducing the family in high status positions. Cultural capital works via superior aesthetic taste, and that taste relates to social position: actual preferences relate to social status. These different categories of capital emphasise that (like for Marx) capital is a form of social relation.
This receiving and social acting begins in childhood, with dispositions of perception, thought and actions towards practices, improvisations, attitudes or bodily movements, and dispositions combine to generate habitus of a practical sense of the world by which all sorts of action strategies can be generated.
Just as Wittgenstein had different language games so Bourdieu understands the divisions of more practical knowledge into fields. Dispositions then are effectively socialisation and habitus is having gained the social world of that field into one's mental make-up. Dispositions are adjusted by the continuing constraints of the social world actually inhabited, including those constraints specific to social status. Thus the combining into a habitus is affected too, and therefore action back into that social world.
The work of Basil Bernstein is relevant here. His suggesting once strong contextualised transmission of middle class values and later weaker transmission of values based on work orientation, comes into this understanding of dispositions; then also comes habitus and having a whole grasp of dispositions among middle class members and therefore the strategies of speaking in elaborate and restrictive codes that give advantage to the middle class. (Care is needed here with a terminology clash: Bourdieu's use of restricted is for high cultural value art whereas expanded is mass art that does not require specialist decoding).
People therefore become acclimatised, skilled operators in their social fields rather like a person drives a car. Most of the time it seems semi-conscious once learned, and social status and power reproduces itself.
The inflexibility of dispositions and durability of each habitus do not account for change so well. So this approach is good for suggesting how things reproduce and stay the same, but not so good for explaining change.
Bourdieu is useful for considering always that the economy is also a symbolic and cultural activity, and utiility lies in these. In terms of consumption it is of course all about taste (utility is ultimately a psychological term of satisfaction in rational choice economic theory), and his postmodern notion is that aesthetics are determined by social position and do not have Kantian independence. Taste is collective. In terms of production those who avoid the mass market can earn the cultural capital of insiders' approval and this can be traded for economic capital with some loss of status (a good example could be how Jack Vettriano sells a lot of his paintings but is regarded as having low cultural capital among artists). Avant garde art is at first seemingly opposed to the economy of commercial production (as in art is sacred and "consecrated" whereas volume production is profane) - until of course the cultural production of this art is recognised as having its own logic of a higher value higher risk economy than the pumping out of prints and popular styles with a clearly more mass economic objective. Who buys cultural value art? Once again it is people of high status who can defer their economic capital into symbolic capital, and who demonstrate their social status derived aesthetic value. Some art is bound to be more economic and popular: cinema, photography and jazz could never return enough cultural capital. Bourdieu about television spoke of "cultural fast food"
Bourdieu has a methodological impact. Theory has to be grounded in research. He did not agree with sociological models that paid little attention to actual empirical realities. Distinction: A Social Critique of the Judgment of Taste was empirical study of taste within social classes and looking at the uneven distributions of aesthetic dispositions. Such capital upholds social authority. He showed social dominance in research findings (especially in education) and how superiority was shown in a process of symbolic reproduction among the socially favoured with a beneficial habitus for them (over working class habitus) generating better strategies. His study of his own locality of peasants in Béarn and why some did not marry was historical as much as sociological.
Bourdieu introduces the notion of participant objectivation. The area of research is an objective world of the habitus. It is important also in this processes to get inside people's motives for actions - their own skills and abilities in acting. Thus objective and subjective are combined. Furthermore, the researcher is not an all seeing objective eye, but should be self-critical in one's own presuppositions. This approach is called doing reflexive sociology.
There are a number of criticisms to consider.
First of all it is quite possible to have high cultural capital surpluses and high economic capital surpluses. The works of Jane Austen have not lost their high cultural capital simply because they sell alot. Nor do great works of art have to sell for less because people buy endless books or posters with them on show. Also categories of art vary internally in their cultural capital: there are art versions of cinema, photography and jazz. Of course Bourdieu discusses a rarified community keeping up its social role by producing academically interpreted artwork. It may be, though, that the dynamics of the art market are purely to uphold savings: that a class of people trade in money-absorbing artworks of no particular value other than in their money-holding role. A widespread view that some art is "just crap" must diminish their cultural value, as with the Turner Prize and the constant need to defend it, but these artworks continue to trade and be emblems of wealth, and carry on demanding high prices for passing between the wealthy and institutions.
Secondly there seems to be some overlap in symbolic and cultural capital. If cultural capital is socially derived then its task is to uphold social status and is a purchase. Visits to the opera have this social role, in the UK, via high seat prices and so some people identify with it. Culture is symbolic anyway, and art joins music in being less precise symbolic forms of expression than words. Education is more than investment in forms of reproducing honour, but is an investment into the cultures of words and skills with presentation strategies that translate into social and economic gain. Presumably networking is a social capital to be transferred into other forms of capital, and is akin to being in a profession, meant in broad sociological terms of a restricted membership of people where members approve new recruits according to its ethos that may involve training and socialisation into it (thus including, sociologically, a "profession" of artists). Professions, of course, set up scarcity and therefore high fees (whatever the ethics of the product being purchased, including that of profession-regulated, service-based, honest advice). Allowing for this kudos of association, I would suggest three forms of capital - economic, social and symbolic, the latter including the cultural.
Thirdly there is some lack of clarity about the terms doxa, dispositions and habitus, and quite when fields are employed or something more total and holistic is being discussed, and one wonders whether there is a need for all these terms at all. Dispositions have a kind of cod-psychology about them; both dispositions and habitus are the process of socialisation and the separation of these seems more analytical than real. The objective-subjective combination is that we have society in our individual heads and that we remain individuals in society with some freedom to act creatively. Furthermore if doxa is a deep paradagm (deeper than Kuhn's understanding) then habitus is a merging of doxa and habitus - society in the individual mind. Once we have dispositions, are we not then socialised into the doxa as we achieve habitus? The habitus is then waiting for us to, well, inhabit it. So perhaps just two terms could suffice - fields and habitus. Nor do we always intend to act in some utilitarian manner by increasing stocks of different forms of capital, and arguably some forms of capital as described are not utilitarian. The material-spiritual exchange that Marcel Mauss discusses might be called utilitarian at one level, but given the material-spiritual difference it might be called sacrificial or even tribal.
Bourdieu represents an approach to cultural theory, grounded in the empirical and what groups of people do, to be discovered by participant objectivation (why not participant observant objectification?). He tries to set this out logically through use of plenty of terminology. Well, here is the reflexive part: he is trying to acquire symbolic (including cultural) capital of the sociologists with whom he networked, by using his own rarified analytical terminilogy for their academic approval, when it might be a lot simpler and presentable to more people. It might sell a few more books if it did become clearer, and it might be more coherent and therefore increase both its economic and symbolic capital.
Pierre Bourdieu was born 1 August 1930 in the Béarn area of France. He died January 23 2002 from cancer. He studied Philosophy at the École Normale Supérieure under Louis Althusser and was a schoolteacher at Moulins between 1955 and 1956. Then for two years he was conscripted into the military in Algeria and wrote Sociologie d'Algérie, the Algerians, published in 1958, as a result - looking at the Berbers under colonialism and seeing what their original kinship structres were. These structures were at variance from social action, and so structure and action needed to be combined. He went on to teach at the University of Algiers to 1960 and on to universities at Paris and Lille up to 1964. A longer job was from 1964-1981 as Director of Studies at École Pratique des Hautes Études as well as being Director of the Centre de Sociologie Européen from 1968 and becoming Professor of Sociology at the Collège de France in 1981. Bourdieu was anti-globalisation and fought against neo-liberal dominance.
Old Mutual plc Interim Results
Old Mutual plc Economic Capital at 31 December 2007
The Old Mutual Group Economic Capital position (based on a target 'A' rating) as at 31 December 2007 is £4.6 billion. This compares favourably with the Available Financial Resources (AFR) of the Group of £7.9 billion and represents a solvency margin of 73%. The total diversification benefit, allowing for diversification both between and within regional businesses, is 39%.
This is the second time that Old Mutual has disclosed its Economic Capital position. In the first disclosure, as at 31 December 2006, Economic Capital stood at £4.1 billion. The corresponding AFR of the Group was £7.1 billion, giving an economic surplus of 73%.
The Old Mutual Group Economic Capital position (based on a target 'A' rating) as at 31 December 2007 is £4.6 billion. This compares favourably with the Available Financial Resources (AFR) of the Group of £7.9 billion and represents a solvency margin of 73%. The total diversification benefit, allowing for diversification both between and within regional businesses, is 39%.
This is the second time that Old Mutual has disclosed its Economic Capital position. In the first disclosure, as at 31 December 2006, Economic Capital stood at £4.1 billion. The corresponding AFR of the Group was £7.1 billion, giving an economic surplus of 73%.
Methodology
Old Mutual defines its Economic Capital requirement as the value of assets required to ensure that it can meet in full its obligations to policyholders and senior creditors at a 99.93% confidence level, which is the probability placed on a target A-rated bond not defaulting in the next year. Old Mutual has adopted a one-year Value-at-Risk approach, which is common market practice and is consistent with current Solvency II proposals.
The Old Mutual approach is to examine the impact of possible risk events on its economic balance sheet, by performing a number of stress tests (or "shocks"), where each shock has been calibrated to a 99.93% confidence level. A number of the more material risks (for example, interest rate risk and equity risk) are typically assessed using stochastic modelling, based on simulations obtained from an Economic Scenario Generator. Less material risks, and in particular, non-economic risks are modelled deterministically.
The calculated capital requirements for each risk are then combined using a correlation matrix to reflect the fact that all of the risks are not expected to occur simultaneously (i.e. are not perfectly correlated). The assumed correlations between each pair of risks are those that may occur under stressed scenarios, which may differ, typically adversely, from those that are exhibited under more normal conditions.
Available Financial Resources ("AFR")
The Group's AFR is defined as the value of assets held by the Group in excess of its economic liabilities, and which could be used over the coming year to meet its Economic Capital requirements. In principal, for banking, general insurance and asset management business, AFR is the initial Net Asset Value. For life business, AFR is the initial embedded value of the business.
For the purpose of assessing the Group's capital strength, cross-shareholdings between business units are unwound to remove 'double-counting' and to understand the capitalisation of each, in isolation, relative to its risk exposure.
Old Mutual companies included in the result
The following businesses are included in Old Mutual's Group Economic Capital figures.
The Economic Capital requirement has been calculated through a detailed process of identifying, quantifying and aggregating the impact of risks across the Group's principal business units. Risks are classified into six categories - Market, Credit, Liability, Business, Operational, and Currency.
Nedbank has a different risk classification, based on Basel II, so these risks have been reclassified for inclusion within Old Mutual's aggregated Group results. The diagram below shows the breakdown of sub-risks by key risk category.
Nedbank has a different risk classification, based on Basel II, so these risks have been reclassified for inclusion within Old Mutual's aggregated Group results. The diagram below shows the breakdown of sub-risks by key risk category.
Market Risk
This captures the worst case value change over the one-year time period as a result of changes in specified financial risk factors (for example, equity and real estate returns, and yield curve shifts), where the changes are applied to policyholder liabilities, assets backing these liabilities and the assets not directly backing these liabilities.
Credit Risk
This captures the worst case value change over the one-year time period as a result of credit defaults, rating changes and spread moves, where the changes are applied to fixed interest holdings and receivables of the company.
This captures the worst case value change over the one-year time period as a result of credit defaults, rating changes and spread moves, where the changes are applied to fixed interest holdings and receivables of the company.
Liability Risk
This captures the worst case value change over the one-year time period as a result of fluctuations in current insurance claims experience and revisions to estimates of future insurance claims experience.
For life insurance, this relates to the fluctuations in the incidence of mortality, longevity, morbidity and insured accident and disability events.
For general insurance, this relates to the adequacy of existing reserves to meet claims arising from elapsed exposure periods, and of earned premiums over the scenario period to meet claims arising from that period of exposure (including claims arising from catastrophes).
This captures the worst case value change over the one-year time period as a result of fluctuations in current insurance claims experience and revisions to estimates of future insurance claims experience.
For life insurance, this relates to the fluctuations in the incidence of mortality, longevity, morbidity and insured accident and disability events.
For general insurance, this relates to the adequacy of existing reserves to meet claims arising from elapsed exposure periods, and of earned premiums over the scenario period to meet claims arising from that period of exposure (including claims arising from catastrophes).
Business Risk
This is the fundamental risk associated with 'being in business'. It captures the worst case value change over the one-year time period due to fluctuations in volume, margin, expenses and lapse experience (including only non-market related lapses).
Operational Risk
This captures the worst case value change over the one-year time period due to the occurrence of unexpected one-off events (internal or external) in relation to people, processes or systems. Examples include systems failure, process errors, control failures, fraud, litigation, staffing issues, regulatory breach and external disruption. Old Mutual has adopted a bottom-up scenario analysis through its business units to assess the capital to be held to mitigate this risk.
Group Currency Risk
We test the solvency of each region separately to the same Group standard, in order to ensure solvency on a standalone basis per region. In addition, we recognise the risk that exchange rates move adversely should capital be transferred across the Group. The Group diversification benefit is reduced accordingly to allow for this.
Liquidity Risk
This reflects the risk that Old Mutual does not have sufficient cash flow available to meet its financial obligations as they fall due. Group and business unit treasury teams monitor and control liquidity risk within the Old Mutual Group. An Economic Capital requirement is not calculated to meet this risk, since Old Mutual believes that holding capital is not an effective and efficient way to manage liquidity risk.
This reflects the risk that Old Mutual does not have sufficient cash flow available to meet its financial obligations as they fall due. Group and business unit treasury teams monitor and control liquidity risk within the Old Mutual Group. An Economic Capital requirement is not calculated to meet this risk, since Old Mutual believes that holding capital is not an effective and efficient way to manage liquidity risk.
Limitations
Old Mutual recognises that the risks captured within an Economic Capital framework cannot capture all possible risks that may occur over the following 12 month period. In particular, the risk of capital loss owing to decisions yet to be taken, e.g. strategic risks, cannot realistically be modelled.
Our Economic Capital model is becoming increasingly robust. During the last year we have carried out a thorough review of risk coverage, assumptions and governance processes.
The results continue to show that a substantial margin exists between the Group AFR and Economic Capital requirement, supporting the view that the Group is strongly capitalised on an economic basis.
Old Mutual recognises that the risks captured within an Economic Capital framework cannot capture all possible risks that may occur over the following 12 month period. In particular, the risk of capital loss owing to decisions yet to be taken, e.g. strategic risks, cannot realistically be modelled.
Our Economic Capital model is becoming increasingly robust. During the last year we have carried out a thorough review of risk coverage, assumptions and governance processes.
The results continue to show that a substantial margin exists between the Group AFR and Economic Capital requirement, supporting the view that the Group is strongly capitalised on an economic basis.
Group Results
Old Mutual's Group Economic Capital requirement as at 31 December 2007 is £4.6 billion. The corresponding AFR of the Group was £7.9 billion, giving an economic surplus of 73%.
As at 31 December 2006, Old Mutual's Group Economic Capital stood at £4.1 billion, when the AFR of the Group was £7.1 billion - also giving an economic surplus of 73%.
Old Mutual's Group Economic Capital requirement as at 31 December 2007 is £4.6 billion. The corresponding AFR of the Group was £7.9 billion, giving an economic surplus of 73%.
As at 31 December 2006, Old Mutual's Group Economic Capital stood at £4.1 billion, when the AFR of the Group was £7.1 billion - also giving an economic surplus of 73%.
The progression of these financial results is as follows:
Economic Capital has increased from 2006 to 2007 largely due to enhanced recognition of the underlying risk profile, updates in assumptions and revised methodology.
AFR has increased largely due to an increase in retained earnings.
The results confirm that the Group is strongly capitalised on an economic basis. A comfortable surplus also exists within each of our South African, US and European regions, meaning that the Group is not reliant for its economic solvency on the need to transfer capital between geographies.
AFR has increased largely due to an increase in retained earnings.
The results confirm that the Group is strongly capitalised on an economic basis. A comfortable surplus also exists within each of our South African, US and European regions, meaning that the Group is not reliant for its economic solvency on the need to transfer capital between geographies.
The Economic Capital requirement is split as follows:
Market risk represents the largest element of group Economic Capital split by risk type. This includes the impact of both assets backing policyholder liabilities and shareholder assets. Liability risks constitute relatively little of the Group Economic Capital since they are relatively weakly correlated with other risks. The mix of other risks is well spread.
The pre-diversified Economic Capital split by region remains broadly unchanged from the 2006 position.
The pre-diversified Economic Capital split by region remains broadly unchanged from the 2006 position.
Diversification benefit
Old Mutual benefits from the diversification of its Group business segments and the territories in which it operates. Consequently the Group Economic Capital requirement is lower than the sum of the standalone Economic Capital requirements of the separate business units.
This diversification benefit of 39% as at 31 December 2007 arises since risks in different business units are highly unlikely to crystallise at exactly the same time and because of the benefit of operating in diverse territories. If the diversification benefit had been defined as only diversification across but not within business units, the resultant figure would have been 17% as at 31 December 2007.
Old Mutual benefits from the diversification of its Group business segments and the territories in which it operates. Consequently the Group Economic Capital requirement is lower than the sum of the standalone Economic Capital requirements of the separate business units.
This diversification benefit of 39% as at 31 December 2007 arises since risks in different business units are highly unlikely to crystallise at exactly the same time and because of the benefit of operating in diverse territories. If the diversification benefit had been defined as only diversification across but not within business units, the resultant figure would have been 17% as at 31 December 2007.
Ongoing developments
Old Mutual continues to refine its Economic Capital methodology in line with emerging best practice, and looks for ways to make enhancements to its models in order to further improve the robustness of the results being produced. The stress tests applied in calculating Economic Capital are regularly reviewed and revised if necessary.
The European Commission is continuing to develop its Solvency II framework for insurance companies and Old Mutual monitors developments in line with emerging Solvency II practice. Significant developments are fed back into Old Mutual's Economic Capital models, and Old Mutual continues to prepare for Solvency II.
How does Old Mutual use Economic Capital
Old Mutual is increasingly using Economic Capital in a number of ways to inform business decisions and actions.
Economic Capital plays a significant role in risk monitoring and control in the Group, providing the key measurement tool used in Old Mutual's developing risk appetite framework. The risk appetite framework will set targets and monitor risk exposures for capital at risk, earnings at risk, cash flow at risk and operational risk at both business unit and group level.
Old Mutual uses Economic Capital to measure and monitor performance of business units allowing for risk and the cost of Economic Capital required to support that risk. The 2009-2011 business plans will contain both projected Economic Capital and risk-adjusted performance targets for each business unit for the first time.
Old Mutual is currently making good progress in implementing a market-consistent methodology for the calculation of its Embedded Value for the year ending 31st December 2008. As part of the revised methodology, Economic Capital will form an input into the required capital and non-hedgeable risk components of the market-consistent Embedded Value.
Economic Capital is also playing an increasingly important role in risk-based pricing across the Group, with a number of examples where Economic Capital is one measure on which metrics for new product development and pricing are based.
Business units within the Group have also started considering Economic Capital in decisions around reinsurance retention levels.
Governance
Economic Capital at Old Mutual is measured, monitored and reported under a rigorous governance process involving senior executives as well as the Board. The diagram overleaf shows the sign-off process for the setting of Group Economic Capital policy and assumptions and the production of results.
Old Mutual continues to refine its Economic Capital methodology in line with emerging best practice, and looks for ways to make enhancements to its models in order to further improve the robustness of the results being produced. The stress tests applied in calculating Economic Capital are regularly reviewed and revised if necessary.
The European Commission is continuing to develop its Solvency II framework for insurance companies and Old Mutual monitors developments in line with emerging Solvency II practice. Significant developments are fed back into Old Mutual's Economic Capital models, and Old Mutual continues to prepare for Solvency II.
How does Old Mutual use Economic Capital
Old Mutual is increasingly using Economic Capital in a number of ways to inform business decisions and actions.
Economic Capital plays a significant role in risk monitoring and control in the Group, providing the key measurement tool used in Old Mutual's developing risk appetite framework. The risk appetite framework will set targets and monitor risk exposures for capital at risk, earnings at risk, cash flow at risk and operational risk at both business unit and group level.
Old Mutual uses Economic Capital to measure and monitor performance of business units allowing for risk and the cost of Economic Capital required to support that risk. The 2009-2011 business plans will contain both projected Economic Capital and risk-adjusted performance targets for each business unit for the first time.
Old Mutual is currently making good progress in implementing a market-consistent methodology for the calculation of its Embedded Value for the year ending 31st December 2008. As part of the revised methodology, Economic Capital will form an input into the required capital and non-hedgeable risk components of the market-consistent Embedded Value.
Economic Capital is also playing an increasingly important role in risk-based pricing across the Group, with a number of examples where Economic Capital is one measure on which metrics for new product development and pricing are based.
Business units within the Group have also started considering Economic Capital in decisions around reinsurance retention levels.
Governance
Economic Capital at Old Mutual is measured, monitored and reported under a rigorous governance process involving senior executives as well as the Board. The diagram overleaf shows the sign-off process for the setting of Group Economic Capital policy and assumptions and the production of results.
The Group Economic Capital methodology provides a framework to establish a common yardstick for measuring and managing risk and capital. This methodology is intended as a foundation, based on which each business unit has its own methodology, consistent with the Group framework.
The Chief Financial Officer of each business unit and at Group level, with assistance from the Chief Risk Officer and Chief Actuary as appropriate, has responsibility for the ownership and sign-off of Economic Capital requirements.
The Group Actuarial function is responsible for recommending assumption changes to the Economic Capital Implementation Committee 1 , reviewing and challenging business unit submissions and producing the aggregated Group result and associated reports. The Group result is signed off by the Economic Capital Implementation Committee and ultimately the Group Audit Committee and Board. The Group Risk function is responsible for agreeing the methodology for assessing operational risk and reviewing business unit operational risk assessments. The Group Actuarial and Group Risk functions also advise the Economic Capital Implementation Committee in setting policy for the Group.
Economic Capital results are also reported to the Group Capital Management Committee, chaired by the Group Finance Director.
The Chief Financial Officer of each business unit and at Group level, with assistance from the Chief Risk Officer and Chief Actuary as appropriate, has responsibility for the ownership and sign-off of Economic Capital requirements.
The Group Actuarial function is responsible for recommending assumption changes to the Economic Capital Implementation Committee 1 , reviewing and challenging business unit submissions and producing the aggregated Group result and associated reports. The Group result is signed off by the Economic Capital Implementation Committee and ultimately the Group Audit Committee and Board. The Group Risk function is responsible for agreeing the methodology for assessing operational risk and reviewing business unit operational risk assessments. The Group Actuarial and Group Risk functions also advise the Economic Capital Implementation Committee in setting policy for the Group.
Economic Capital results are also reported to the Group Capital Management Committee, chaired by the Group Finance Director.
Do Big Banks Need More Capital?
"The Basel Committee on Banking Supervision, in its October meeting, believes that the implementation of the Basel II capital framework would have gone some distance to alleviate the current global credit crunch which has resulted from the sub-prime lending crisis. Nout Wellink, the chairman of the Basel Committee on Banking Supervision observed that the accord is designed to combat liquidity risk and would have improved the robustness of valuation practices and market transparency for complex and less liquid products." - Chase Cooper, October 11, 2007
With all due respect to the Nout Wellink and the other members of the BCBS, we do not believe that the implementation of the Basel II proposal or anything that looks remotely like it would have alleviated the ongoing collapse of the market for complex structured assets. When an entire asset class literally dies in a matter of weeks, the risk is infinite. To us, measuring the liquidity or market risk of a Structured Investment Vehicle ("SIV"), with or without the Basel II framework, makes about as much sense as using statistics to predict corporate credit defaults.
Remember too that most of Basel II is based upon the very quantitative models and rating agency methods which caused the subprime crisis, thus offers of assistance from Basel II's creators within the BCBS should be viewed with caution. Basel II merely mimics the business processes of the Sell Side investment houses, systems which are intended first to enable new financial transactions and, as a secondary matter, manage the risk. See our comment in the American Banker regarding same. If you want to know what we really think, read our comments to US regulators on the Basel II proposal.
The quarter trillion dollar financial sinkhole caused by the collapse of the market for structured subprime assets illustrates, to us at least, why a rational implementation of Basel II should require MORE CAPITAL for large universal banks. These are institutions which emphasize unpredictable business lines such as principal trading, creating and selling OTC derivatives, and investment banking, but also take risk in lending and other traditional banking activities. Citigroup (NYSE:C) is an excellent example of a bank facing rising risks from both quarters.
Or take the unhappy example of Ken Lewis, CEO of Bank of America (NYSE:BAC). He said last week regarding the poor performance of his second-tier investment banking shop: "I have had all of the fun I can stand in investment banking at the moment. So to get bigger [in investment banking] is not really something I want to do." BAC has a pretty modest trading book risk exposure and a top-performing banking book compared to asset peers, so you can understand why Lewis is seriously pissed off when his investment bankers drop the ball.
No matter which large global bank you choose, the portion of bank earnings attributable to capital markets activities is neither stable nor predictable, especially when derivatives (and investment bankers) are involved. Even a bank with a relatively small banking business like BAC can take a "surprise" hit from the trading book. What neither regulators nor bankers nor Sell Side researchers will admit, though, is that periodic "surprises" are the norm for universal banks, thus arguments about Basel II allowing banks to maintain less capital are patently ridiculous.
To understand our skepticism about the ability of banks to manage their trading books "safely and soundly," particularly using derivative tools such as VaR and Merton models which populate the Basel II framework, consider the words of physicist Stephen Hawking from his lecture Does God Play Dice?:
The idea that the state of the universe at one time determines the state at all other times, has been a central tenet of science, ever since Laplace's time. It implies that we can predict the future, in principle at least. In practice, however, our ability to predict the future is severely limited by the complexity of the equations, and the fact that they often have a property called chaos. As those who have seen Jurassic Park will know, this means a tiny disturbance in one place, can cause a major change in another. A butterfly flapping its wings can cause rain in Central Park, New York. The trouble is, it is not repeatable. The next time the butterfly flaps its wings, a host of other things will be different, which will also influence the weather. That is why weather forecasts are so unreliable.
Risk within the largest banks, on and off balance sheet, has risen exponentially over the past half century. Gaming instruments like cash settlement derivatives and structured assets are the preferred "investment" vehicles of the Sell Side firms, but these instruments and the humans who create and trade them add a huge degree of complexity and unpredictability to the financial behavior of these banks. And the proposed Basel II agreement, far from constraining this trend toward greater and greater risk taking and complexity, will enable banks to extend risk taking further and further into unpredictable areas which were once forbidden for depository institutions.
In view of the current market meltdown caused by "SIVs" and other types of derivatives, we think it is reasonable to ask whether under Basel II large universal banks with significant trading book activities don't need more capital than under Basel I. Three years ago, IRA asked that very question and set about estimating the amount of Economic Capital required to keep a bank's external credit rating stable in the face of a serious loss to the trading book. We used the portfolio-level data from the FDIC to create a consistent measure of Economic Capital for all US banks.
Below is a summary of the Economic Capital model in the IRA Bank Monitor for the 20 largest US banks by total assets. Institutions whose ratio of Economic Capital to Tier One Risk Based Capital ("RBC") exceeds one standard deviation from the average for all banks over $100 billion in total assets are shown in red. The SD for the large bank group was 1.7:1 while the mean was 1.3:1. A low or negative Risk Adjusted Return on Capital or "RAROC" may indicate an institution with excessive risk and/or inferior asset and equity returns.
With all due respect to the Nout Wellink and the other members of the BCBS, we do not believe that the implementation of the Basel II proposal or anything that looks remotely like it would have alleviated the ongoing collapse of the market for complex structured assets. When an entire asset class literally dies in a matter of weeks, the risk is infinite. To us, measuring the liquidity or market risk of a Structured Investment Vehicle ("SIV"), with or without the Basel II framework, makes about as much sense as using statistics to predict corporate credit defaults.
Remember too that most of Basel II is based upon the very quantitative models and rating agency methods which caused the subprime crisis, thus offers of assistance from Basel II's creators within the BCBS should be viewed with caution. Basel II merely mimics the business processes of the Sell Side investment houses, systems which are intended first to enable new financial transactions and, as a secondary matter, manage the risk. See our comment in the American Banker regarding same. If you want to know what we really think, read our comments to US regulators on the Basel II proposal.
The quarter trillion dollar financial sinkhole caused by the collapse of the market for structured subprime assets illustrates, to us at least, why a rational implementation of Basel II should require MORE CAPITAL for large universal banks. These are institutions which emphasize unpredictable business lines such as principal trading, creating and selling OTC derivatives, and investment banking, but also take risk in lending and other traditional banking activities. Citigroup (NYSE:C) is an excellent example of a bank facing rising risks from both quarters.
Or take the unhappy example of Ken Lewis, CEO of Bank of America (NYSE:BAC). He said last week regarding the poor performance of his second-tier investment banking shop: "I have had all of the fun I can stand in investment banking at the moment. So to get bigger [in investment banking] is not really something I want to do." BAC has a pretty modest trading book risk exposure and a top-performing banking book compared to asset peers, so you can understand why Lewis is seriously pissed off when his investment bankers drop the ball.
No matter which large global bank you choose, the portion of bank earnings attributable to capital markets activities is neither stable nor predictable, especially when derivatives (and investment bankers) are involved. Even a bank with a relatively small banking business like BAC can take a "surprise" hit from the trading book. What neither regulators nor bankers nor Sell Side researchers will admit, though, is that periodic "surprises" are the norm for universal banks, thus arguments about Basel II allowing banks to maintain less capital are patently ridiculous.
To understand our skepticism about the ability of banks to manage their trading books "safely and soundly," particularly using derivative tools such as VaR and Merton models which populate the Basel II framework, consider the words of physicist Stephen Hawking from his lecture Does God Play Dice?:
The idea that the state of the universe at one time determines the state at all other times, has been a central tenet of science, ever since Laplace's time. It implies that we can predict the future, in principle at least. In practice, however, our ability to predict the future is severely limited by the complexity of the equations, and the fact that they often have a property called chaos. As those who have seen Jurassic Park will know, this means a tiny disturbance in one place, can cause a major change in another. A butterfly flapping its wings can cause rain in Central Park, New York. The trouble is, it is not repeatable. The next time the butterfly flaps its wings, a host of other things will be different, which will also influence the weather. That is why weather forecasts are so unreliable.
Risk within the largest banks, on and off balance sheet, has risen exponentially over the past half century. Gaming instruments like cash settlement derivatives and structured assets are the preferred "investment" vehicles of the Sell Side firms, but these instruments and the humans who create and trade them add a huge degree of complexity and unpredictability to the financial behavior of these banks. And the proposed Basel II agreement, far from constraining this trend toward greater and greater risk taking and complexity, will enable banks to extend risk taking further and further into unpredictable areas which were once forbidden for depository institutions.
In view of the current market meltdown caused by "SIVs" and other types of derivatives, we think it is reasonable to ask whether under Basel II large universal banks with significant trading book activities don't need more capital than under Basel I. Three years ago, IRA asked that very question and set about estimating the amount of Economic Capital required to keep a bank's external credit rating stable in the face of a serious loss to the trading book. We used the portfolio-level data from the FDIC to create a consistent measure of Economic Capital for all US banks.
Below is a summary of the Economic Capital model in the IRA Bank Monitor for the 20 largest US banks by total assets. Institutions whose ratio of Economic Capital to Tier One Risk Based Capital ("RBC") exceeds one standard deviation from the average for all banks over $100 billion in total assets are shown in red. The SD for the large bank group was 1.7:1 while the mean was 1.3:1. A low or negative Risk Adjusted Return on Capital or "RAROC" may indicate an institution with excessive risk and/or inferior asset and equity returns.
The IRA Bank Monitor -- Economic Capital (June 30, 2007)
Source: Federal Deposit Insurance Corp/The IRA Bank Monitor
These Economic Capital profiles reflect not only the "on balance sheet" assets of the subsidirary banks of these holding companies, but also off balance sheet derivatives dealing, and include an analysis of trading, investing and lending activities. The growing trading book risk of the largest banks argues strongly in favor of requiring more capital to support these activities. Institutions such as C and JPMorgan (NYSE:JPM) which engage in extensive derivatives dealing with and lending to hedge funds, and/or off-balance sheet financial activities using SIVs, should arguably be given higher ratios of EC/Tier One RBC, subject to credible mitigation.
While many large banks appear to need additional capital, it is worthy of note that the average ratio of Economic Capital to Tier One RBC for the other 8,000 plus banks in the US is well-below 1:1. This suggests that smaller, less complex banks could get by with far less capital and thereby significantly boost equity returns.
Looking at Economic Capital based upon published regulatory disclosure seems, to us at least, a basic point of departure for making Basel II a truly useful tool for maintaining the safety and soundness of all banks. While the larger players in the banking industry once saw Basel II as a means of further increasing leverage and risk-taking, the subprime crisis may provide regulators with a lever to compel banks to hold more capital against visible and contingent risks such as SIVs. But do bodies like the BCBS have the courage to fight that battle?
While many large banks appear to need additional capital, it is worthy of note that the average ratio of Economic Capital to Tier One RBC for the other 8,000 plus banks in the US is well-below 1:1. This suggests that smaller, less complex banks could get by with far less capital and thereby significantly boost equity returns.
Looking at Economic Capital based upon published regulatory disclosure seems, to us at least, a basic point of departure for making Basel II a truly useful tool for maintaining the safety and soundness of all banks. While the larger players in the banking industry once saw Basel II as a means of further increasing leverage and risk-taking, the subprime crisis may provide regulators with a lever to compel banks to hold more capital against visible and contingent risks such as SIVs. But do bodies like the BCBS have the courage to fight that battle?
New Approaches to Measurement and Modeling
Under the terms of the final framework of the Basel II Capital Accord, approved in June 2004 by regulators from the G-10 countries, banks will, for the first time, be required to set aside capital for the specific purpose of offsetting operational risks. These are defined as nonfinancial risks resulting from the failure of “internal processes, people, or systems, or from external events.” In fact, operational risks, which include everything from property damage to cyber risk to employee fraud, represent a full range of property and casualty risks faced by corporations in every industrial sector.
Within the financial services industry, the new regulatory regime has accelerated the development of tools for quantifying and managing operational risk. In recent decades, that industry has been in the forefront of efforts to quantify both financial and nonfinancial risk. Over time, the industry’s new tools for measuring and managing operational risk are likely to be useful to nonfinancial corporations of many kinds.
The New Regulatory Regime
Basel II introduces a far more sophisticated approach to bank solvency than Basel I, the prior international capital accord dating from 1988. The earlier regime represented little more than a flat tax on banks, which were required to hold capital equal to 8 percent of their assets. The new accord differentiates among risks with far greater precision. In addition to introducing new requirements for rating credit risk, Basel II requires large, internationally active banks to calculate their operational risk capital from the bottom up, using both internal and external loss data.
Banks are, of course, in the business of taking financial risks, such as credit risk and market risk, on terms that they expect will prove profitable. Nonfinancial risk arises because a firm may incur an operating loss due to a nonfinancial cause. Although financial risks currently have far greater importance for banks, operational risks can still be substantial. Under Basel II, for example, more than $50 billion of regulatory capital would be required to protect banks from operational risk in the United States alone. Furthermore, as banks continue to reduce their financial risks through the securitization of assets and other means, operational risks will likely account for a growing share of the overall risks these institutions face.
The Basel II accord covers two types of non-financial risk:
* Internal event risk – or losses due to internal failures, such as fraud, operating errors, systems failures, legal liability, and compliance costs.
* External event risk – or losses due to uncontrollable external events – for example, earthquakes or other natural catastrophes, terrorism, and acts of God.
Economic Capital
Ultimately, the question of how much capital should be allocated to operational risk is a problem of measurement. Within the banking industry, economic capital has become the accepted standard for measuring the intrinsic capital needed to support risk taking. Economic capital is a tool that can be used within an organization to make decisions, motivate management, and report on risk for purposes of internal risk accounting.
As shown in the graph above, economic capital defines risk in probabilistic terms as a point in a loss distribution. A bank that holds sufficient capital to protect against losses at the 99.9 percent level has a .1 percent risk of default. This is roughly equivalent to the default risk of a single-A rated bond and equivalent to a bank holding capital sufficient to maintain a single-A bond rating. Since different banks have different solvency standards, they need to hold capital sufficient to protect against losses at different levels of confidence. As the graph suggests, an institution with a triple-A rating needs to hold more economic capital than one with the same risk profile but a rating of single-A.
Certain types of operational losses are expected. These are high-frequency/low-severity events – for example, routine processing errors in a high-volume business. Rather than setting aside capital for these losses, a bank can budget for them as an expected cost of doing business. It is only the larger-thanexpected losses that create downside volatility in a bank’s earnings. Economic capital is required as a backstop against these low-frequency/high-severity events – the rare events that threaten the solvency of the institution and contribute to the right-hand “tail” of the graph above.
Overcoming Practical Obstacles
For a bank or nonfinancial corporation to apply the theory of economic capital, it must have a sizable body of reliable data on the risks it faces. Under the impetus of Basel II, large banks have stepped up their efforts to refine the measurement of operational risk. In practice, this can be quite difficult. Internal data is necessarily scarce because, by definition, low-frequency/ high-severity losses seldom occur within any one bank.
At the same time, external data may be difficult to apply because different institutions are not directly comparable. A well-run institution will have excellent business processes, auditing, and controls that reduce significantly the risk of operational losses. If another bank has incurred a large operational loss, the well-run bank will want to know whether the loss resulted from bad luck or poor management. To overcome these obstacles, banks have begun to collect data systematically, both internally and externally, and to experiment with techniques for modeling operational risks.
Having quantified their operational risks, financial institutions are in a better position to select strategies for managing them. Setting aside capital is just one of the possibilities. In fact, an ounce of management prevention may often be worth a pound of capital cure. After quantifying the potential impact of accounting irregularities, IT security breaches, workplace violence, property damage, and other types of operational risk, executives can protect shareholder value by anticipating crisis events before they occur. This may include the analysis of vulnerabilities, the integration of a program across multiple disciplines within the organization, and the testing of the plan. The September 11 terrorist attack brought home the value of such measures: Those institutions that had focused most on preparedness, process, and controls fared best in the crisis.
Today, financial institutions are taking specific steps to improve the management of operational risk, including improvements in organizational alignment, clarification of accountability, increases in control/audit, and greater internal data collection. Some banks are using economic capital measures to strengthen these functions. A number, for example, now tie managers’ annual bonuses to the risk-adjusted performance of their respective business units.
Generating Value Through Insurance
To the extent that operational losses cannot be mitigated by internal processes and controls, they can often be insured by third parties. Basel II offers the most advanced banks an opportunity to reduce the capital they set aside for operational risk by as much as 20 percent through the purchase of insurance.
As discussed above, retaining risk exposes a firm’s capital base to loss. While banks set aside specific capital for this purpose, nonfinancial corporations generally do not. Nonetheless, whether or not retained risk is specifically funded through an accounting accrual, a self-insurance fund, or a captive insurer, a firm’s base of equity and debt capital must respond to a loss. Economic capital analysis is, therefore, applicable to corporations of every type.
Even if no loss has actually occurred, retained risk implies that the firm’s base of capital is working. When a firm chooses to buy insurance, it utilizes insurance industry capital in lieu of its own. From this perspective, the purchase of insurance can be viewed as a value-generating activity.
Traditionally, few, if any, firms have looked at insurance in this way. In the event of a loss, insurance has generally been perceived as merely making a bad circumstance less bad – an otherwise undesirable expense. In fact, insurance is the principal way a firm can regulate the use of its capital to support operational risk.
As risk imposes a cost on an organization, reducing that cost generates value. A decision to retain risk is appropriate when it is rewarded by an adequate economic return. An optimal insurance design generates maximum value for the firm. But to create such a design, a decision maker must be able to distinguish good insurance deals from bad.
How can senior managers act on these concepts? The same computing tools that make it possible to model future outcomes can also be used to allocate economic capital and to identify optimal insurance solutions.
Risk imposes economic costs in the form of expected losses and capital exposure. The modeling process allows these components to be estimated both before (gross) and after (net) insurance. Value is created for the policyholder when insurance reduces these costs to an extent greater than the premium.
Independent of the expected losses, capital exposure, and premium, there is no optimal insurance decision. For example, we cannot say that a firm of a given size will have an ideal retention level. We can say, however, that a firm may have the capacity to retain a certain amount of risk before feeling unacceptable levels of financial pain. And we can determine the desirability of retaining risk only with knowledge about the underlying risk and the opportunities available in the insurance marketplace.
Valuing D&O Insurance
Corporate governance liability is an important subset of insurable operational risks. Mercer Oliver Wyman (MOW), an MMC subsidiary, has used the theoretical principles described above to develop a model of the economics of both buying and underwriting directors and officers liability (D&O) insurance. In 2003, when the market for D&O coverage was particularly hard, we wanted to know: (1) were insurers achieving returns significantly above their cost of risk? and (2) did the purchase of D&O insurance still add value for policyholders?
The modeling work utilized securities class action lawsuit data held by NERA Economic Consulting, another MMC subsidiary. Explicit quantification of D&O loss characteristics enabled us to model the economics of risk transfer from sell-side and buyside perspectives using a simulation-based approach.
Initially, the sell-side perspective was examined to assess whether recent industry-wide premium increases still yielded “economic” returns – i.e., returns at the insurers’ hurdle rate. The insight from this study was that industry-wide premiums were 15 to 30 percent below insurers’ total cost of risk from 1998-2002 and 30 percent above insurers’ total cost of risk in 2003. The latter pricing levels would be “justified” if claims attributable to 2003 ultimately increase by 25 percent over historical trends. Given the degree of uncertainty in the prevailing corporate governance environment, such an increase was a distinct possibility.
The client-specific buy-side modeling used both industry loss distribution data and company-specific data. Despite premium growth that had brought premiums to above-hurdle levels, we found that for our client the various tranches of coverage were actually priced at the lower end of the bid/ask spread. In this instance, we found a total risk transfer benefit of approximately $10 million.
This analysis demonstrates that the purchase of insurance can be a win/win transaction for both buyer and seller. The key factor here is diversification. As indicated in the chart above, the insurer holds a large, well-diversified portfolio of potential losses, but the policyholder enjoys only a limited diversification benefit. Even in a hard market, purchasing insurance can add value. As the insurance market softens and premiums go down, value to the policyholder goes up. Our analysis shows that in the soft market, transferring risk becomes more efficient.
A Perspective on Modeling
The modeling described in this article is not a panacea. Models, by their very nature, simplify reality and sometimes oversimplify it. Risks can and do arise from unforeseeable sources. Furthermore, the output of a model can only be as good as the data fed into it.
Nevertheless, risk modeling of this kind is likely to play a growing and beneficial role in decisions to purchase insurance. In contrast to rules of thumb that have commonly been used in the past – for example, how much insurance did we buy last year? what is the competition doing? – quantitative modeling provides a more objective basis for decisions. Even when it does not result in radically different choices, quantitative modeling can provide statistical validation for decisions that have been made in a largely intuitive way.
Spurred by Basel II, banks can be expected to make increased use of economic capital, quantitative modeling, and other analytical tools for measuring and mitigating operational risk. Over time, many nonfinancial corporations will likely follow suit.
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