Economic capital
Economic capital is the amount of capital that we allocate as a buffer against potential losses from business activities, based upon our assessment of risks. It differs from Basel II regulatory capital, as NIBC sometimes assesses the specific risk characteristics of its business activities in a different way than the general regulatory method. Relating the risk-based economic capital of each business to its profit, results in a calculation of its Risk-Adjusted Return On Capital (RAROC). Economic capital and RAROC are key tools used in support of our capital usage process. These tools assist in allocating our shareholders’ equity as efficiently as possible based on expectations of both risk and return. The usage of economic capital is reported once every two weeks to the ALCO. The ALCO resets the maximum allocation level of economic capital to and within each business, taking into account business expectations and our desired risk profile. Economic capital allocation is based on a one-year risk horizon, using a 99.9% confidence level. This confidence level means that there is a probability of 0.1% that losses in a period of one year will be larger than the allocated economic capital.
Economic capital methodology
NIBC uses the business model of each activity as the basis for determining the economic capital approach. If the business model of an activity is trading, distribution, or investment for a limited period of time, we use a market risk approach based upon VaR and scaled to a one-year horizon to calculate the economic capital usage. A business model equal to ‘buy-to-hold’ or investment to maturity means that a credit risk approach is applied based upon estimations of PD and LGD. For all activities, add-ons for operational risk are calculated. In addition, NIBC allocates economic capital for business risk, reputation risk and model risk on a bank-wide level.
The economic capital approach differs from the regulatory capital approach, in which only the trading books are assigned a market risk approach. Activities that have a business model equal to distribution or investment for a limited period of time are, in some cases, assigned a credit risk approach in the regulatory capital framework due to Basel II regulations or regulatory industry practice. For these business model categories, NIBC applies a market risk approach in the economic capital framework similar to the trading activities, as for all of these activities the market price becomes relevant at a certain point in time. Risks and economic capital are therefore monitored accordingly.
The main differences between the economic capital and regulatory capital framework exist for the residential mortgage portfolio, the European Structured Credits portfolio and NIBC’s interest rate mismatch position. Economic capital is determined by a market risk approach for these activities because of their business model. The regulatory capital approach for these portfolios is either included in credit risk (mortgages and structured credits) or not included at all within Basel II Pillar I (mismatch position). As economic capital methodology may differ significantly among financial institutions, it is more appropriate to compare the regulatory capital figures in note 59 to the Consolidated Financial Statements for the purpose of industry comparison of market risk and credit risk exposures.
Economic Capital Usage
We allocate economic capital to all our business activities in the form of limits set by the ALCO, and calculate the amount of economic capital usage of each business based on the risk of its activities.
- For our corporate loan portfolio, which uses a major part of our economic capital, we calculate economic capital usage using a credit risk approach largely based upon the Basel II regulatory capital formula and an add-on for concentration risk;
- For our debt investments and trading portfolios, residential mortgage portfolio and the interest rate mismatch position, we use a market risk approach to determine economic capital usage. We calculate economic capital usage for these portfolios using VaR calculated with four years of historical data and scaled to a one-year horizon;
- For our mezzanine portfolio, we calculate economic capital usage by applying a credit risk approach based upon the Basel II regulatory capital formula; and
- For our private equity investment portfolio, we use fixed percentages.
The following table shows the economic capital usage per business activitity. In its Market Risk Economic Capital calculation, NIBC takes diversification effects into account between credit spread and interest rate risk. Diversification occurs from the fact that not all risks will occur at the same time. Therefore, the sum of economic capital for these market risks on a stand-alone basis will be higher than the amount of economic capital if these risks are combined. This reduction of economic capital is defined as diversification. The economic capital framework does not take into account diversification effects between the different risk categories (credit, market and operational risk).
The diversification effect in the economic capital calculations is higher in 2008 than in 2007. The reason is an increased diversification effect in 2008 between interest rates and credit spreads, as well as the incorporation of a combined market risk VaR framework for residential mortgages and debt investments and trading portfolios. As a result of the latter, diversification effects between these two activities are now measured.
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Economic capital per business activity |
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|
in eur millions |
2008 |
2007 |
Difference (in %) |
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|
Corporate loan portfolio |
428 |
518 |
(17) |
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|
Residential mortgage portfolio |
280 |
239 |
17 |
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|
Debt investments and trading portfolio |
241 |
176 |
36 |
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|
Mezzanine and private equity portfolio |
201 |
151 |
33 |
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|
Interest rate mismatch portfolio |
122 |
104 |
17 |
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|
Operational and other risk |
95 |
122 |
(22) |
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|
Reputation risk |
100 |
100 |
0 |
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|
Business risk |
100 |
100 |
0 |
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|
Model risk |
20 |
20 |
0 |
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|
Economic capital usage |
1,585 |
1,530 |
4 |
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|
Diversification effect |
(295) |
(122) |
141 |
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|
Total economic capital usage net of diversification effect at 31 december |
1,290 |
1,408 |
(8) |
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The changes in the usage of economic capital at year-end 2008 are owed to a variety of factors. The decrease of 17% noted for our corporate loan portfolio was the result of a decline in the size of this portfolio during 2008.
On the other hand, the usage of the residential mortgage portfolio increased by 17%. This increase was due to the increased credit spread volatility in 2008. The market risk methodology for these assets is based upon the most advantageous methodology under IFRS. Instead of applying a securitisation exit model based upon RMBS spreads, NIBC now uses an approach based upon the origination spreads of residential mortgages.
Furthermore, the economic capital usage of our debt investments and trading portfolios increased by 36%. Despite further de-risking of these portfolios in 2008, economic capital usage of these activities rose as a result of increased credit spread and interest rate volatility in 2008.
An increase (of 33%) was also noted for the mezzanine and private equity portfolio due to the growth in the size of these portfolios.
Lastly, the economic capital usage of our interest rate mismatch position increased by 17%, because of an increase in interest rate volatility in 2008.
