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.
Industry Practices in Credit Risk Modeling and Internal Capital Allocations: Implications for a Models-Based Regulatory Capital Standard: Summary of Presentation
I. WHY SHOULD REGULATORS BE INTERESTED IN CREDIT RISK MODELS? Bank supervisors have long recognized two types of shortcomings in the Basle Accord's risk-based capital (RBC) framework. First, the regulatory measures of "capital" may not represent a bank's true capacity to absorb unexpected losses. Deficiencies in reported loan loss reserves, for example, could mask deteriorations in banks' economic net worth. Second, the denominator of the RBC ratios, total risk-weighted assets, may not be an accurate measure of total risk. The regulatory risk weights do not reflect certain risks, such as interest rate and operating risks. More importantly, they ignore critical differences in credit risk among financial instruments (for example, all commercial credits incur a 100 percent risk weight), as well as differences across banks in hedging, portfolio diversification, and the quality of risk management systems. These anomalies have created opportunities for "regulatory capital arbitrage" that are rendering the formal RBC ratios increasingly less meaningful for the largest, most sophisticated banks. Through securitization and other financial innovations, many large banks have lowered their RBC requirements substantially without reducing materially their overall credit risk exposures. More recently, the September 1997 Market Risk Amendment to the Basle Accord has created additional arbitrage opportunities by affording certain credit risk positions much lower RBC requirements when held in the trading account rather than in the banking book. Given the prevalence of regulatory capital arbitrage and the unstinting pace of financial innovation, the current Basle Accord may soon become overwhelmed. At least for the largest, most sophisticated banks, it seems clear that regulators need to begin developing the next generation of capital standards now--before the current framework is completely outmoded. "Internal models" approaches to prudential regulation are presently the only long-term solution on the horizon. The basic problem is that securitization and other forms of capital arbitrage allow banks to achieve effective capital requirements well below the nominal 8 percent Basle standard. This may not be a concern--indeed, it may be desirable from a resource allocation perspective--when, in specific instances, the Basle standard is way too high in relation to a bank's true risks. But it is a concern when capital arbitrage lowers overall prudential standards. Unfortunately, with the present tools available to supervisors, it is often difficult to distinguish these cases, especially given the lack of transparency in many off-balance-sheet credit positions. Ultimately, capital arbitrage stems from the disparities between true economic risks and the "one-size-fits-all" notion of risk embodied in the Accord. By contrast, over the past decade many of the largest banks have developed sophisticated methods for quantifying credit risks and internally allocating capital against those risks. At these institutions, credit risk models and internal capital allocations are used in a variety of management applications, such as risk-based pricing, the measurement of risk-adjusted profitability, and the setting of portfolio concentration limits. II. THE RELATIONSHIP BETWEEN PDF AND ALLOCATED ECONOMIC CAPITAL Before discussing various credit risk models per se, it may be helpful to describe how these models are used within banks' capital allocation systems. Internal capital allocations against credit risk are based on a bank's estimate of the probability density function (PDF) for credit losses. Credit risk models are used to estimate these PDFs (see chart). A risky portfolio is one whose PDF has a relatively long, fat tail--that is, where there is a significant likelihood that actual losses will be substantially higher than expected losses, shown as the left dotted line in the chart. In this chart, the probability of credit losses exceeding the level X is equal to the shaded area under the PDF to the right of X. …
The Accuracy of Reported Insurance Status in the MEPS
Estimates of the number of insured and uninsured Americans are watched by numerous policymakers and the public, yet studies find respondents do not report their insurance status perfectly. Using four sources of validation data, including surveys of employers and providers, this paper assesses the quality of respondents' reports of private insurance and uninsurance in the Medical Expenditure Panel Survey Household Component (MEPS-HC), a nationally representative household survey. Regression analysis is used to assess the extent to which factors are associated with disagreements in reported insurance status across sources.