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Appropriate Economic Capital For Banks – What Does It Take?

This article explains, at a very high level, the purpose of maintaining economic capital. It also explains the challenges in estimating the appropriate level of economic capital for a bank or a central bank. Each step in the process of modelling of the economic capital needs to be examined deeply and deliberated with a suitable allowance for errors of judgment. This requires a high level of technical expertise, experience, and humility. Let us hope we do get all of these.

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The last meeting of the Management and the Board members of the Reserve Bank of India (RBI) with the Minister and the senior officials of the Ministry of Finance (MOF) of the Government of India (GOI) ended with the decision for constitute a few committees to examine some of the contentious issues. This has been hailed by most analysts and public commentators as a sign of good progress, mainly because the two sides, RBI and GOI, have agreed to refer the issues to the committees. It is to be noted that neither side has expressed any tangible agreement to the views of the other side.

The committees will be formed shortly and we will get to know their views on the issues. The issues are of highly technical nature and it would require specialists in the fields of banking and financial markets to examine them. The composition of the committees and their terms of reference will be crucial for an optimal delivery from them. While that is a subject for thought, let us independently understand some of the technical aspects underlying the issues to be addressed. Here, we are looking at the following issues:

  1. What should be the appropriate level of capital maintained by the RBI?
  2. What should be the minimum level of capital to be maintained by Indian banks?
  3. Should the process for putting banks under prompt corrective action (PCA) be relaxed?

Each of these issues deserves detailed deliberation. In this article, we look at the first issue – appropriate level of economic capital that should be maintained by the RBI.

The basic principles for arriving at an appropriate level of capital are the same for all banks, including RBI. Let us see how the economic capital is modelled for a bank.

Economic capital of a Bank: The economic capital (EC) of a bank is defined as the amount of capital required to be maintained in order to withstand losses to the bank at a pre-defined level of worst-case scenario. As is obvious from this definition, there are several elements that go into the computation of the EC. The most challenging aspect, however, is the estimation of the potential loss in a worst-case scenario.

Since we are talking of potential scenarios that may occur in the future, it is impossible to predict them accurately. The losses can crystallise at various levels, and can be expected with varying levels of probability in the future. Let us consider an example, where a rise in crude oil price can cause a loss to a bank.  

Let us visualise a situation where a bank is concerned only about the impact of oil prices on its profits. In order to estimate the risk from oil prices, let us think of some potential pessimistic scenarios. It is possible that in certain scenarios playing out over the next one year, Brent crude oil price may go up to US$80 or 100 or 150, as has been seen in the past as well. Taking this further, in a certain scenario, there is also a small (but non-zero) probability of the oil price moving up to US$ 300. At each level of these high oil prices, a bank with an exposure to oil price risk would suffer a certain amount of loss. If a bank wishes to survive through such loss, it would require a certain level of capital. So, how much capital should a bank maintain?

The decision process for a bank would depend on two key points:

  1. Up to what level does it expect the oil price to move up, and with what level of probability?
  2. Each level of oil price would translate to a given level of loss for the bank. Up to what level of the oil price, or equivalently, up to what level of loss, would the bank like to be protected from insolvency?

For example, a bank may estimate that the probabilities of oil price exceeding USD 100, USD 150 and USD 300 are 20%, 10%, and 0.1% respectively. This means that if the bank maintains adequate capital to absorb the losses from oil price rise up to USD 100, there is still a 20% chance that the bank may face insolvency. So, a bank can choose to limit the probability of its own default to 20%, 10% or 0.1% by maintaining the required amount of capital for absorbing losses at the respective levels of oil prices.

The more secure (or solvent) a bank wants to be, the higher will be the capital required to be maintained by it. But, capital has a cost attached to it. So, a bank needs to judiciously choose what level of solvency it wants and the related capital it is ready to maintain. It is not an easy decision for the stakeholders.

Challenges:

The above analysis assumes that a bank has a fair idea of the probabilities of oil price at various levels. That is a difficult task in the best of circumstances. There have been various econometric techniques used by banks to estimate the potential losses based on future events. However, no bank can say that its technique is perfect.  These techniques keep getting revised as the banks learn from their experiences.

To add to this, there are multiple risk factors that a bank has to deal with at any point of time. So, the degree of complexity and uncertainty on the prediction of future outcomes also multiplies several-fold.

A prediction outcome is as only good as the data, the model structure, and the underlying assumptions used for the same. The data used is based mostly on either historical observations or derived from related market observations. The econometric models that are used to forecast the future trends of the risk factors are often subject to errors. Finally, assumptions underlying the model are just that. So, predictions are fraught with errors.

In order to deal with prediction errors, banks often maintain an additional buffer of capital over and above the minimum economic capital as per the model. This is the reason, regulators also insist on a margin of safety in the level of capital maintained by banks.  

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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Dr. Hemant Manuj

The author is Associate Professor & Area Head – Finance at SPJIMR.

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