Obtaining abundant "economic capital" and implementing risk-adjusted profit measures can allocate capital that will be useful to measure profitability and make decisions to enter or exit a certain line of business.
In recent times, the importance that risk-adjusted profit measures have taken to measure the performance obtained by organizations vis-à-vis financial institutions has been recognized, which is why different methods have been followed, such as "Profit on assets". or the "Benefit on own resources". But the perspective has changed. Before, "Regulatory Capital" was used as the basis for allocating capital to each business unit, now "Economic Capital" is being used instead of "Regulatory Capital".
Thus, in the pursuit of maximizing business value, the basis for achieving sustainable financial returns must be structured on the basis of risk-adjusted profit on economic capital, subject to the restrictions imposed by the requirements of "Regulatory Capital".
Diversification
The capital measured for each business line does not take into account the effects of diversification between different businesses.
Below are the different methods for measuring economic capital and risk-adjusted profit measures, which should be used to allocate economic capital, measure profitability, and make decisions to enter or exit certain lines of business.
Economic capital and risk analysis
- Aggregation
Many of the companies have started to see the market with a new perspective and this is the reason why they are being successful. Analyzing your environment using the amount of risk associated with your activities can measure unexpected losses from trading activities. This technique can be extended to take into account all the benefits, not just the gains due to changes in value.
By taking historical information that allows predicting future situations and that carry some benefit, you can somehow obtain the statistical distribution of these benefits, which will reflect the impacts of the events that are caused by the different risks.
Statistical analysis can set a specific confidence level that can be obtained by «Risk Benefits» measures that, taken to measures, can calculate the corresponding level of economic capital.
- Disintegration
Instead of obtaining a single figure that reflects the combined effects of two of the different risks, the risks can be considered separately, using specific models, the "Capital for credit risk", the "Capital for market risk" and the Capital for operational risk.
Once these capital calculations have been made by type of risk, economic capital is obtained by a simple addition of its factors.
Many of the companies have started to see the market with a new perspective and this is the reason why they are being successful.
Economic capital measures
In the case of business lines, three economic capital measures must be considered:
- Not diversified
The economic capital necessary to service each business line can be calculated using the techniques described above. However, if the economic capital of each business line is added, the result will exceed the calculated economic capital, this is because the measured capital for each business line does not take into account the effects of diversification between different businesses.
- Diversified
Diversification is obtained through the portfolio effect, calculated as a measure of diversified economic capital.
- Marginal
The economic capital of an individual business line is the difference between the entire gross capital and the net amount after including the benefits of a business line. The sum of the amounts of marginal capital is less than economic capital because it includes the part of capital not assigned to specific lines of business.
Uses of economic capital measures
- To allocate capital
Diversified capital must be used, as the capital assigned to a business unit will depend on the contribution of each business unit to the overall volatility of market value.
Then there will be businesses that receive less capital based on the contribution they have to diversification, although individually they have more risk than others. In other words, its benefits are not correlated with other lines of business, which favors maintaining profits at different stages of the economic cycle.
- To measure performance
Non-diversified capital will have to be used, since to measure the manager of a business line, it is necessary to rely on what is under his control, both the risks he can manage and the benefits he can generate. And therefore the benefits of diversification cannot be imputed to it.
- For entry / exit decisions
In this case you will have to use marginal capital, which measures how much additional capital is required to enter a business or how much capital is released when leaving a line of business.
