Economic Capital and Financial Risk Management for Financial Services Firms and Conglomerates (Finance and Capital Markets Series)

The authors present a comprehensive and timely discussion of economic capital and financial risk management for financial services firms and conglomerates. Topics covered include: *the different types of risks that firms collect; *risk governance issues; *how stress testing can be used to measure risk; *the provision of a clear and precise definition of economic capital; *the different types of capital that are eligible to back regulatory capital, and; *the development of models that can be used to estimate a firm's economic capital requirements. A unique feature of the book is that, for the first time, the economic capital requirements of financial services firms across the entire risk spectrum, from the short end to the long end, are considered in one book. The authors develop models to estimate the economic capital requirements of banks, asset management firms, life and non-life insurance firms, pension funds, and the financial services conglomerates that comprise these firms. Economic capital is compared to regulatory capital and regulatory capital arbitrage is discussed. The diversification benefit present in financial services conglomerates is quantified and the practical management of this diversification benefit is dealt with. The authors give new insights into capital management and performance measurement for financial services conglomerates and provide detailed descriptions of the main financial services firm regulatory capital changes that are ongoing at the time of writing. This superb and original book charts new ground in the practical application of economic capital for financial services firms and conglomerates. It is required reading for all capital allocation and risk professionals. Contents......Page 4 List of Figures......Page 8 List of Tables......Page 14 Preface......Page 16 Acknowledgments......Page 19 Disclaimer......Page 20 List of Abbreviations......Page 21 1.1 Our approach to risk......Page 24 1.3 Our approach to infrastructure......Page 25 1.4 Structure of the book......Page 26 2.1 Introduction......Page 28 2.2 Types of risks collected......Page 29 2.3 Risk collection......Page 36 2.4 Risk mitigants......Page 39 2.5 Summary......Page 42 3.1 Introduction......Page 44 3.2 Risk identification......Page 45 3.3 Risk management infrastructure and processes......Page 48 3.4 Risk measures, appetite and limits......Page 50 3.5 Relate capital to risk......Page 53 3.6 Reporting processes......Page 54 3.7 Independent reviews of internal controls......Page 55 3.8 Summary......Page 56 4.2 Deterministic stresses......Page 57 4.3 Stochastic stresses......Page 58 4.4 Multivariate nature of the risk variables......Page 60 4.5 Causal nature of the multivariate dependencies......Page 61 4.7 Stress confidence level......Page 62 4.8 Relative pros and cons......Page 63 4.9 Summary......Page 64 5.1 Defining economic capital......Page 65 5.2 Time horizon for determining economic capital......Page 66 5.3 Exclusion of the capital assets backing a firm's business......Page 67 5.5 Uses of economic capital......Page 68 5.6 Economic capital calculation in practice......Page 71 5.7 Relationship of economic capital with regulatory capital requirements......Page 72 5.8 Summary......Page 74 6.2 The role of capital......Page 75 6.3 Categorization of capital quality......Page 76 6.4 Capital deductions and limits......Page 78 6.5 Summary......Page 79 7.1 Introduction......Page 81 7.2 Specific low dimensional stochastic models......Page 82 7.3 The general high dimensional stochastic model......Page 98 7.4 Specific high dimensional stochastic model......Page 108 7.5 Other stochastic models......Page 114 7.6 Summary......Page 115 8.2 Retail bank examples......Page 116 8.3 Stochastic wholesale bank example......Page 140 8.4 Summary......Page 152 9.1 Introduction......Page 154 9.2 Traditional non profit life insurance......Page 155 9.3 Unit linked life insurance......Page 169 9.4 General/health/property and casualty insurance......Page 175 9.5 Summary......Page 185 10.3 Risk and economic capital......Page 186 10.4 Summary......Page 187 11.1 Introduction......Page 189 11.2 Stochastic with profits life insurance investment guarantee example......Page 190 11.3 Stochastic with profits life insurance smoothing example......Page 213 11.4 Pensions......Page 237 11.5 Summary......Page 241 12.1 Introduction......Page 243 12.2 Aggregate versus bottom up approaches to economic capital......Page 245 12.3 Bottom up approach anomalies......Page 246 12.4 Pros and cons of the two approaches......Page 249 12.5 Double counting of capital......Page 250 12.6 Example of economic capital for a financial services conglomerate......Page 251 12.7 Management of diversification benefits......Page 257 12.8 Summary......Page 259 13.1 Introduction......Page 260 13.2 Pricing......Page 261 13.3 Performance measurement......Page 263 13.4 Leverage......Page 267 13.5 Allocating Tier 1 capital to match economic capital......Page 271 13.6 Business mix optimization......Page 277 13.7 Implementation issues......Page 278 13.8 Regulatory capital arbitrage......Page 281 13.9 Summary......Page 284 14.1 Introduction......Page 285 14.3 Banking and asset management......Page 286 14.4 Insurance......Page 295 14.5 Financial groups directive......Page 307 14.6 Accounting changes......Page 310 14.7 Summary......Page 311 15 Summary and Conclusions......Page 312 Appendix......Page 313 References......Page 339 C......Page 341 J......Page 342 R......Page 343 W......Page 344 The authors present a comprehensive discussion of economic capital for financial services firms including: definition and theory of Economic Capital, discussion of the types of risks that firms collect, regulatory change, stress testing and stochastic approaches, banking theory and applications, insurance theory and applications, asset management theory and applications, comparison of banking/insurance/asset management approaches, conglomerate theory and applications. The book charts new ground in the practical application of economic capital for financial services and is vital reading for all capital allocation and risk professionals