Dear David,
I have some confusion in regard to EC and regulatory capital. Can you help me out?
a) extract from "Best summary yet of operational risk under Basel II" (http://www.bionicturtle.com/learn/article/best_summary_yet_of_operational_risk_under_basel_ii/)
• It's not symmetrical
• Expected loss (EL) + Unexpected loss (UL) = Value at risk (VaR) by the way, this is an different from credit Var and market Var where the Var = UL only, correct?
• As usual, VaR doesn't say anything (doesn't help) about the distribution of extreme losses
• The expectation is that reserves, not regulatory capital, cover expected losses (of course, the Accord checks for that. If a bank doesn't cover EL with reserves, then they'll need more regulatory capital). Regulatory capital is for unexpected losses (this isn't shown below)
b) extract from one practice question about economic capital
III. Firms whose capital exceeds their required regulatory capital are firms that employ their capital inefficiently and their shareholders would benefit if they used some of their capital to repurchase shares or increase dividends. The answer is that this statement is true. You further explained that:" A firm may employ the economic capital as its own internal assessment to check the efficiency of overall amount of capital it holds. Therefore, I and III are correct. "
c) my thought:
From the practice question b), it seems that the key assumption here is that regulatory capital is always more than or equal to EC. . A firm achieves optimum capital holding only when it holds capital amount equal to EC, therefore concluding that a firm holding regulatory capital is holding excessive, unnecessary capital.
However, if I look at a) which concerns the operational risk, I can't help wondering if in the case where a firm DOES hold reserve for expected losses and is therefore required to hold a regulatory capital equal to unexpected losses only, the regulatory capital (=UL) is actually LOWER than the EC (=Var= EL+UL).
I'm confused by this apparent contradiction. Can you please clarify this? Thanks.
Cheers!
Liming
04/10/2009
I have some confusion in regard to EC and regulatory capital. Can you help me out?
a) extract from "Best summary yet of operational risk under Basel II" (http://www.bionicturtle.com/learn/article/best_summary_yet_of_operational_risk_under_basel_ii/)
• It's not symmetrical
• Expected loss (EL) + Unexpected loss (UL) = Value at risk (VaR) by the way, this is an different from credit Var and market Var where the Var = UL only, correct?
• As usual, VaR doesn't say anything (doesn't help) about the distribution of extreme losses
• The expectation is that reserves, not regulatory capital, cover expected losses (of course, the Accord checks for that. If a bank doesn't cover EL with reserves, then they'll need more regulatory capital). Regulatory capital is for unexpected losses (this isn't shown below)
b) extract from one practice question about economic capital
III. Firms whose capital exceeds their required regulatory capital are firms that employ their capital inefficiently and their shareholders would benefit if they used some of their capital to repurchase shares or increase dividends. The answer is that this statement is true. You further explained that:" A firm may employ the economic capital as its own internal assessment to check the efficiency of overall amount of capital it holds. Therefore, I and III are correct. "
c) my thought:
From the practice question b), it seems that the key assumption here is that regulatory capital is always more than or equal to EC. . A firm achieves optimum capital holding only when it holds capital amount equal to EC, therefore concluding that a firm holding regulatory capital is holding excessive, unnecessary capital.
However, if I look at a) which concerns the operational risk, I can't help wondering if in the case where a firm DOES hold reserve for expected losses and is therefore required to hold a regulatory capital equal to unexpected losses only, the regulatory capital (=UL) is actually LOWER than the EC (=Var= EL+UL).
I'm confused by this apparent contradiction. Can you please clarify this? Thanks.
Cheers!
Liming
04/10/2009
