Benefits of Implementing Economic Capital Software
Generally speaking, Canadian credit unions and mid-sized banks are well-capitalized. So, the question really becomes what are the benefits of implementing Economic Capital (ECAP) system?
ECAP is the amount of capital required to protect the organization against economic insolvency over a one-year time-frame. For example, using a 99.70% Confidence Interval, we can say that the capital set aside is adequate to offset Unexpected Losses that have the frequency of occurrence once out of 666.6 years.
From stakeholders’ perspective there are three important factors to consider:
- Management: The management also needs to better understand the capital requirements of their business. They should be able to explain and justify their views of such capital requirements to supervisors and other users of financial statements. By demonstrating to the regulator (through ICAAP reporting) that ECAP and enterprise risk management (ERM) systems are in place, the management of credit unions and banks could potentially add additional assets to the balance sheet which could increase the net income and, ultimately capital
Providers of capital: Providers of the capital want to earn an adequate return.
They should be able to judge the effective return on the capital employed in the
lending business. The cost of this return needs to be incorporated in the pricing of
the loans that lending institutions make. The users of financial statements need to
understand whether they are being adequately compensated. Therefore, an implicit
interest exists amongst members/shareholders in establishing:
- A “correct” level of return under given parameters so that the return on capital from the providers of capital’s perspective is not deemed too low, when compared with industry benchmarks
- Earn risk-adjusted return in line with the Canadian industry benchmark of c. 18%
- Reducing pre-payments: From borrowers’ perspective, borrowers with good ratings should not be charged to subsidize borrowers with poor credit rating. In the absence of right tools to determine fair loan pricing, ‘good credit’ ends-up subsidizing ‘bad credit’. Retention rate declines when borrowers with good credit consider they are being over-charged
In nutshell, if the return delivered to members is below a benchmark hurdle rate, a lending
institution can find itself trapped in capital dilution zone, i.e., if the rate of return is
below the hurdle rate, then suppliers of capital end-up ‘bailing-out’ the borrowers,
resulting into the dilution (as opposed to the accretion) of capital. From an industry
standpoint, this is shown below:
For the reasons noted herein, Economic Capital (ECAP) is an extremely powerful tool for all constituencies interested in the financial health of a lending institution.
Many credit unions and small-midsized banks believe that the formulaic approach used by the supervisors does not appropriately reflect the processes and procedures for effectively managing risk; these credit unions feel confident that their risk management practices would be positively reflected in the determination of economic capital. For example, the credit unions may want to be able to benefit from the diversification of concentration risk and seek recognition of their superior credit management. Credit union management will also want to measure performance, taking account of the capital that is effectively being employed in different business areas.
As Canadian credit unions’ regulations converge with OSFI, formulaic approach to the assessment of solvency levels will also likely be phased-out. Formulaic approaches do not necessarily cope with changes in the operating environment or generally allow for the benefit of the various forms of diversification.
At BBA, we believe that ERM/ECAP implementation should be integrated with strategy-setting. ERM redefines the value proposition of risk management by elevating its focus from the tactical to the strategic. The greater the gaps in the current state and the desired future state of the organization’s risk management capabilities, the greater the need for ERM infrastructure to facilitate the advancement of risk management capabilities over time.
Using BBA’s ECAP software (ECAPLeader), credit unions/small-midsized banks will be able to address the above challenges and develop competitive advantage by:
- Allowing greater comparability of results across products, portfolios, branches and asset classes. This would be welcomed by regulators and members alike
- Measure and mange concentration risk at granular level: Identify the highest pockets of capital concentration both at portfolio and at transaction level, and develop mitigation strategies and pricing plays
- Standardize the disclosure by splitting overall results into more granular information for management and board members
BBA’s ECAPLeader checks all boxes of a best practice ERM system:
ECAPLeader is organized in two modules:
1. ERM Module
As part of the ICAAP requirement, a credit union’s management is required to identify the risks to which it is exposed to and also assess their risk profile. In our set-up phase, we work with the management to identify the material risks that the credit union/bank is exposed to, taxonomize those risks, assign ownership and develop risk-reduction controls to transform the risks from inherent to residual risks. BBA applies a best practice “risk materiality” framework to determine which risks are material and which risks are non-material.
2. Economic Capital (ECAP) Module
Regulatory requirements to define and cascade risk profile with capital requirements under ICAAP have led to Economic Capital emerging as a standard industry-wide solution. ECAP framework’s appeal to regulators and financial services institutions is driven by several factors:
- Assigns capital subject to institutional selected risk profile (an important requirement)
- ECAP is a consistent method that measures, aggregates and reports different types of risks across businesses, addressing the demands for risk transparency by many stakeholders
- Economic Capital is designed to be an ‘apples to apples’ measure applicable across different types of business, geographies and accounting systems
- Economic capital can also be applied at any level of the institution from a high-level group-wide measure to much more granular levels such as business units, customers and even transactions. It is an excellent capital management tool for financial conglomerates as well as smaller institutions
Economic Capital has applications in different areas, which are:
– Capital Management/Strategic Planning
– Portfolio management
– Performance Measurement
– Limit Setting
In conclusion, ECAP models are risk-sensitive and offer robust measures of the prioritized exposures, and hence are the most appropriate for use in internal capital calculations.