Risk‐Based Capital Allocation Using a Coherent Measure of Risk
This article outlines a procedure for quantifying risk‐adjusted capital reserves that may be used for both performance evaluation and capital allocation. The author identifies and quantifies the sources of risk capital that must be addressed, to cover current investment and withstand market shocks, for any business line that exhibits earnings volatility. The author classifies risk capital into two types: market‐risk capital and earnings volatility‐related capital. Market risk capital may be divided into two categories; risks due to “normal” or “diffusion” type price movements and catastrophic moves or “stress” events. In contrast, earnings volatility‐related capital is directly related to the firm's equity‐at‐risk, in the event that market shocks lead to sustained earnings volatility. The author suggests that these risk‐adjusted capital measures may be used as a benchmark, in conjunction with net earnings, to evaluate performance, or to allocate equity capital across different operations within a firm.
Natural Catastrophe Probable Maximum Loss
ABSTRACT The procedure for estimating probable maximum loss (PML) for natural catastrophes has evolved over the past few decades from a rather simplistic deterministic basis to a more sophisticated methodology based on loss exceedance probability curves, generated using catastrophe modelling software. This development process is reviewed, with an emphasis on the earthquake peril, which, because of its widespread threat to critical industrial installations, has been at the forefront of most PML advances. The coherent risk definition of PML is advocated as an improvement over standard quantile methods, which can give rise to anomalous aggregation results failing to satisfy the fundamental axiom of subadditivity, and so discouraging the pooling of risks.
The choice of capital instruments
A system of bank supervision and regulation should protect taxpayers and the financial system without imposing unnecessary costs on banks. This article focuses on whether existing capital regulations, one of the primary tools of bank supervision and regulation, are imposing unnecessary costs on banks. In particular, the capital requirements may be requiring banks to issue equity when it would be less costly for them to issue subordinated debt. ; The authors obtain evidence on the costs generated by equity issues by examining the type of capital banks issued in response to the capital guidelines of the 1980s, which included a type of debt in capital. The findings suggest that banks prefer to avoid issuing common equity, especially when the ratio of the market price of their stock to its book value is less than one. The results suggest that the option to substitute debt for equity in meeting the capital standards is especially valuable for banks with low market values. The results also suggest that the ability to issue debt as a substitute for equity is more valuable to larger banks.