Outline good practice in governing an economic capital framework and judge the main concerns that arise.
The idea
Good governance of an economic capital framework starts at the top. The board and senior management approve the policy, understand the key assumptions and limits, and make real use of the results in limits, pricing and performance measurement. Model development, parameter setting and validation need clear ownership, with validation independent of both the developers and the business lines whose capital charge depends on the output. Changes to methodology and parameters should be documented, approved and monitored, and reporting should show sensitivity to assumptions, not one point estimate. The main concerns are conflicts of interest when business units influence the parameters that set their own capital, model risk and over-reliance on a single number, poor data, weak integration with decisions, and procyclicality when capital rises in downturns. The usual mistake is to treat the model as the control. The exam point is that governance, independence and challenge matter as much as the mathematics.
A practice question
Under good governance practice for an economic capital framework, who holds ultimate responsibility for the framework?
- The board and senior management, who approve policy and key assumptions and see that results are used. - correct
- The business line heads, whose own profit and capital are measured by the framework and who run the model day to day.Why not: Gives control to the units measured by the output, creating a conflict of interest.
- The external auditors, who certify the model each year.Why not: Audit may review controls but cannot own a management framework.
- The model developers alone, since they alone understand the mathematics.Why not: Technical expertise does not remove senior management accountability.
Good practice puts ownership with the board and senior management. They must understand the framework, approve policies and key assumptions, and make sure the results feed decisions.
A harder one
A bank calculates economic capital every quarter and reports it in a risk report, but limits, pricing and bonuses are all set on regulatory capital. What is the most significant governance concern?
- Regulatory capital exceeds economic capital, which shows that the economic capital model must be wrong.Why not: A gap between the measures reflects design differences and is not itself evidence of error.
- The one-year horizon is used, which is inappropriate for economic capital.Why not: A one-year horizon is standard practice, not a governance weakness.
- Economic capital is not used in decisions, so it lacks senior management ownership and challenge. - correct
- A correlation matrix is used for aggregation, which is not acceptable practice.Why not: Correlation-based aggregation is a common approach; the concern is how it is governed.
A framework that is only reported is not embedded. Without use in limits, pricing and performance measurement, the numbers receive little challenge, data quality suffers and senior management has little reason to own it.
The hardest tier
Business unit heads select the correlation and diversification parameters used in the model, and the resulting capital charge feeds directly into their own RAROC and bonus. Which statement identifies the concern and the appropriate control?
- Business heads know their markets best, so ownership of the parameters is appropriate if a risk committee is informed afterwards.Why not: Informing afterwards leaves the conflict in place; units may supply input but should not own the parameters.
- The conflict of interest is real, so parameters should be set and changed under an independent risk function with documented approval, with the business providing input. - correct
- The concern is diversification itself, so all diversification credit should be removed from the model.Why not: Removes a legitimate feature of the model instead of fixing the control over its inputs.
- The concern is the use of economic capital in bonuses, so incentives should be based only on regulatory capital.Why not: Abandons risk-based incentives, one of the main benefits of the framework, instead of fixing control of parameters.
Those whose reward depends on an output should not control its inputs. Good practice places parameter setting and change approval with an independent function, with documentation and challenge, while allowing business input.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Range of practices and issues in economic capital frameworks
- Describe the difficulties met in implementing an economic capital framework when defining and computing risk measures, aggregating risk, validating models, modeling dependency in credit risk, evaluating counterparty credit risk, and assessing interest rate risk in the banking book.
- Set out what the Bank for International Settlements (BIS) recommends supervisors weigh in order to put internal risk measures such as economic capital, which were not built for regulation, to good use.
- Explain how adopting an economic capital framework helps and changes outcomes in four areas: managing the credit portfolio, pricing for risk, analysing how profitable customers are, and shaping management incentives.