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Powering up Economic Capital:
Overcoming Barriers To Achieve
Effective Implementation
July 27th, 2005
Jean-Bernard Caen – DEXIA Head of Economic Capital
<This document presents the point of view of its author, which may differ from DEXIA’s.
It supports an oral presentation and is incomplete without it.
This support is protected by copyright laws.>
© Jean-Bernard Caen 2005 & +
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DEXIA at a glance
 World Leader in Public Finance
• 620b€ (750b$) credit exposure in the USA (41%),
Belgium (14%), France (13%), Italy (12%)
 A diversified Financial Group
• A Retail network in Benelux
• Investment Management Services in Luxembourg
• Capital Market activities
 Highly profitable
• Net Income reached 1.8b€ (2.2b$) in FY 2004, 20% ROE
• Market Capitalization is 20b€ (24b$) – 15th European bank
© Jean-Bernard Caen 2005 & +
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Allocating Economic Capital:
What for ?
 To manage two opposite pressures
PRESSURE OF SHAREHOLDERS (*) FOR AN
INCREASED RETURN ON CAPITAL
Search of Profitability
Reduce capital usage
CAPITAL
Increase capital backup
Search of Safety
PRESSURE OF REGULATORS FOR A BETTER
PROTECTION OF SAVINGS AND DEPOSITS
(*) and policy holders for Insurance Companies
© Jean-Bernard Caen 2005 & +
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Maximal value creation requires
optimal Capital allocation
High
Areas of
Excellence
Capital
Allocation
Expected
Return
Competitors
Arena
Low
Low
Risk
High
√ Capital allocation supports long term value creation
√ Explicit allocation of long term resources
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ECAP potential benefits are huge
 ECAP creates value
• Better strategic development decisions
• Incentives in line with shareholders interests
 ECAP brings in higher returns
• Effective external pricing policy
• Effective internal funds transfer pricing
 ECAP reduces risk
• Reduction of Credit Concentration
• Disclosures transparency reduces risk for shareholders
© Jean-Bernard Caen 2005 & +
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The Insurance Case
 The Insurance specificity is that the policy holder
bear a part of the risks (i.e. of the capital)
• Which part is usually not explicit for easier management of
the trade-off between financial and commercial goals
 Managing Insurance risks is managing one big ALM
• But share- and policy-holders do not have the same risk
aversion and expected return
 Defining a profit sharing rule is an absolute must for
modeling Insurance ALM
• It will form the back-bone of sound economic management
© Jean-Bernard Caen 2005 & +
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The range and scope of
Economic Capital (ECAP)
potential uses are wide
1. Regulatory constraint
2. Common metrics for measuring risks
3. Limits
4. Performance measurement and value analysis
5. Effective pricing of risk
6. Credit Portfolio management
7. Reduction of Excess Capital
8. Managers compensation and incentives in line
with shareholders interest
9. External disclosure of risk profile
Why aren’t these functions implemented?
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The product has big potential benefits.
Where can the production process be blocked?
 ARE BIG POTENTIAL BENEFITS ENOUGH TO:
• Start an Economic Capital function?
YES
 Finance or Risk line?
• Allocate adequate resources?
MAY BE
 The ear of the boss
• Read the out coming results?
MAY BE
 One more reporting…
• Make decisions based upon Economic Capital?
NO
 Too new, too volatile, too strange, too technical
 Difficult to back-test, to handle, to pilot
 THERE IS A REAL HAZARD TO BE STUCK AT THAT STAGE!!
© Jean-Bernard Caen 2005 & +
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CAP…CAP…CAP…
The hen house is noisy
CAPITAL has become a buzzword
• One word with multiple meanings =>
 Which CAPITAL: Accounting? Regulatory? Economic?
• Three referential with many interactions
 Which CAPITAL: Used? Required? Available?
• Three natures of capital
© Jean-Bernard Caen 2005 & +
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Capital faces
ACCOUNTING
REGULATORY
Used
(risk measure)
Required
(by regulators,
rating agencies,
planned
investments)
Available
(maximum loss
coverage)
© Jean-Bernard Caen 2005 & +
Accounting
Equity
8% of Risk
Weighted
Assets
Tier 1 + tier 2
+ tier 3
ECONOMIC
Economic
Equity
(EE)
Economic
Capital
(ECAP)
Available
Financial
Resources
(AFR)
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Different Economic Capital for
different uses?
 Economic Equity (Used)
• Risk, measure, neutral metrics across risks and activities
 Performance assessment, pricing, compensation
 Economic Capital (Required)
• Resources for business development
 Strategic planning, M&A, investments
 Available Financial Resources (Available)
• Maximum loss coverage
 Capital raising, dividend policy, shares buy back
But … aren’t all these functions already
performed without Economic Capital?
© Jean-Bernard Caen 2005 & +
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Clearly, ECAP offers better
decision making…
 … than accounting or regulatory capital.
 But this does not please everybody
• Line managers loose free meals
 Tighter risk control, improved internal funds transfer pricing
• Basel2 project leaders loose power
 Regulatory capital not used for decision making
• Financial control looses control
 Finance people must make room to risk people for strategic planning
• Top management compensation is more volatile
 Quicker grasp of success … and failures
So … wouldn’t some internal
marketing be welcome?
© Jean-Bernard Caen 2005 & +
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To whom may Economic Capital
benefits be sold?
 Sales people
• For retail, well-rated counterparts, collateralized transactions,
ECAP-based RAROC leads to lower cost prices than
regulatory-based RAROC
 Shareholders
• Prime beneficiaries if AFR is greater than ECAP
Difficult to reach; try Financial Communication people
 Top Management
Let’s follow up this promising track…
© Jean-Bernard Caen 2005 & +
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ECAP potential hooks to
management concerns
 Shareholders
• Analysts are quick to press for share buybacks or higher dividends if
they feel the excess capital becomes too high.
• AFR follow-up allows the CFO to effectively manage excess capital
 Rating agencies
• The key to a reasonable cost of funding. Showing out an reasonable
excess capital can comfort rating agencies assessments.
 Regulators
• An unavoidable constraint to bankers and insurers “It is expected that
sophisticated institutions will elect to use formal economic capital models”
(Basel2).
 Competitors
• Most sophisticated banks do have ECAP tools and start using them.
 Compensation
• The toughest challenge but the sweetest pull. Issues of model
validation and transparency become critical to avoid tensions.
© Jean-Bernard Caen 2005 & +
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Take over management tools to
make ECAP a must
 Risk Management reporting
• Much of risk reporting focuses on exposures
• Some info relates to risk factors (VaR for instance)
 Add ECAP as a common metrics to compare risks and their evolutions
 Activity reporting
• Introduce Economic Profit besides more usual ROEs
 Clarify risk/return issues through the analysis of EP changes
 Regulatory reporting
• Compare regulatory and economic capitals and ratios
 Uncover and solve apparent regulatory mishaps
 Strategic planning
• Promote a framework to discuss growth vs. risk issues
 Make friends with Financial Controllers and offer them new insights
© Jean-Bernard Caen 2005 & +
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Search for leverage in key Committees
 New products approval
 Risk committees
• Credit : Big transactions
• Market : Limit settings
 Executive Committees
• Investments
• M&A
 Finance Committees
• Challenge strategic planning
• Reassess ALM risk / return posture
© Jean-Bernard Caen 2005 & +
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Typical “naïve” questions … that
point to the right actions
 Risk-return questions
• “Abnormal” financial forecasts pop up and can be challenged
 Higher return with lower ECAP?
 Also lower return with higher ECAP? (typical when compensation is Income based)
• If return grows quicker than ECAP -> Improved expertise? Better
competitive positioning? Cost cutting?
• If return grows slower than ECAP -> limit capital allocation?
 ROEE analysis
• Include maturity in the judgment
• Locate “too” high ROEs and analyze opportunities for EP growth
 Training
• Self assessment on ECAP
 Handle real objections
• 99,9x%
• Allocation diversification benefits
© Jean-Bernard Caen 2005 & +
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Capitalize on current issues
(example: from Gaap to IFRS 1/2)
ASSETS
Fixed-income commercial loans
Variable-income commercial loans
Fixed-income mortgages
Variable-income mortgages
Consumer loans
 TOTAL ASSETS
 Given guaranties
LIABILITIES
70
140
135
15
40
400
60






Sight deposits
Regulated deposits
Debt securities
Time deposits
Interbank
Equity and reserves
 TOTAL LIABILITIES
130
105
85
30
24
26
400
 Received guaranties
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B/S were initially conceived to provide a reliable profit figure
•To act as a robust base for taxation
•Formal fitting was more important than economic reality
•Historic value of assets and liabilities were adequate for that goal
© Jean-Bernard Caen 2005 & +
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Capitalize on current issues
(example: from Gaap to IFRS 2/2)
LIABILITIES AND EQUITY
ASSETS






Commercial loans AAA
Commercial loans A
Commercial loans BBB
Non securitizable mortgages
Securitizable mortgages
Consumer loans
 TOTAL ASSETS
70
70
70
30
130
40






Sight deposits
Regulated deposits
Debt securities
Time deposits
Interbank
TOTAL LIABILITIES
410




IRB Equity
Available capital (IRB)
Capital gain
TOTAL EQUITY
130
105
85
30
24
374
15
11
10
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Disclosures of risks and liquidity measures
Explicit elements of capital management
More transparency and volatility
© Jean-Bernard Caen 2005 & +
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Economic Capital has a straighforward logic
for shareholders … not for managers
Increasingly sophisticated risk management tools
Regulators
Ratings
agencies
Board
Defend the interest of
Depositors and
the global
financial system
Debt holders
Shareholders
Are searching for
Limit the ability
to take risk
Solvency
Return
Put limits in terms of
Minimum
regulatory
capital for a
given RWA
Minimum T1
capital for AA
rating
Return volatility
i.e. economic
equity
Expected management
Add capital
Add capital
Maximize value
creation
© Jean-Bernard Caen 2005 & +
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Conclusion
 A schopenhauer puts it:
« ALL TRUTH GOES THROUGH THREE STEPS
FIRST IT IS RIDICULED
THEN IT IS OPPOSED
TO FINALLY CONSIDER IT HAS ALWAYS BEEN OBVIOUS »
 Do not consider resting when you reach the third step!
• This is where it all begins…
Thank you for listening
© Jean-Bernard Caen 2005 & +
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