Risk, Regulatory Capital and Capital Management

1. Risk, Regulatory Capital and Capital Management Tim Shepheard-Walwyn Group Risk Director Barclays PLC

2. The Capital Conundrum • Should regulatory capital and internal economic capital be the same? • If so, what theory of capital underpins the Basel Committee approach? • How does the Basel system address non portfolio business risks which are core to corporate finance theory? • What has operational risk got to do with all this?

3. The EL Revolution • The recognition of EL as a cost removes the single biggest portfolio based driver of volatility • Capital is there to cover Unexpected Loss in the portfolio AND IN THE REST OF THE BUSINESS • Earnings risk becomes the biggest determinant of internal capital allocation

4. A bit of history • Basel Accord was a ‘fix’ to deal with the problem of the Japanese banks • It was a rough solvency measure and never intended to be a basis for capital management • But in a stable world, with interest margins stable and historic cost provisioning, a portfolio based volatility measure was a reasonable simplifying model

5. Why allocate economic capital? • Normal WACC methods don’t work because deposits are available at risk free rate • Portfolio optimisation is not possible without an internal pricing mechanism • Is the rule shareholder based (i.e. improve Sharpe Ratio), or • Is the rule debtholder (incl depositor) based (i.e. minimise risk)

6. How is economic capital linked to risk? • Economic capital cannot be the same as total capital • Economic capital does not need to be the same as total risk • Shareholder risk (volatility) does need to be allocated • Debtholder risk (stress) is a constraint on the business

7. Risks and time horizons • Shareholder view (volatility) and debtholder view (stress) must reflect all risks • Portfolio risks (credit & market) are only 30% of risk according to market prices • Other risks (Operational and business risks) are becoming the dominant consideration for management • But time horizons differ - portfolio risks matter more in short term, business risk in long term

8. Implications (1) • Operational risk debate is a proxy for inadequacy of Basel model • Must have greater focus on business risks (including operational losses) • Must distinguish between equityholder (volatility) and debtholder (stress) view • Must define purpose and time horizon for regulatory capital

9. Implications (2) • Regulatory capital will never be fully aligned with ‘economic capital’ allocation • Exercise is shareholder value maximisation subject to regulatory capital constraint • Regulatory constraint is minimum level of acceptable default probability

10. A way forward? • Recognise the different perspectives of regulators and firms • Avoid excessive sophistication • Base regulatory capital on stress measures not volatility measures • Apply stress testing to business revenues as well as portfolios • Don’t forget liquidity

11. Equity at risk - An alternative calculation for regulatory capital Capital = [E(Earnings) - Stress Revenues - Stress Portfolio - Stress Costs] x 3 Advantages: Simple, practicable, comparable

12. Conclusion • Internal ratings approach is a big step in the right direction • But full alignment between regulatory and economic capital is a chimera • Recognise the problem and stop while we are ahead • Don’t overengineer the process. If it can be simple, keep it simple