Economic Capital Value - Assignment Example

Economic Capital Value Economic capital is the total amount of capital risk held by companies of financial services to allow it to overcome difficulties. An example of this difficulty is credit risks. They do this often by using some measures of risks like the value at risk (Var). Economic capital might also be used in the reporting and measuring operational market risks that occur may be in a financial organization. Economic capital value is very important especially in a financial organization through the following ways that help it to manage rising risks in the organization. The management of a bank can use the estimates of economic capital (EC) to allocate or distribute capital across their stream of businesses, and also to promote the units that provide good desired profits per unit of risk. Most financial institutions and even banks are faced with very long uncertainties of their future that they do intend to be responsible or accountable for. When a bank may want to determine what amount of capital they need for them to remain solvent in a time horizon or at a certain confidence level, economic capital (EC) is that which is considered as the capacity of capital risk from the perspective of the bank. Economic capital (EC) aims at supporting the decisions of a business (Barrieu and Ravanelli, 13). The estimates of economic capital (EC) can also be covered by Tier 1, Tier 2 and Tier 3 elements, or the definitions used by agencies at a rating, and also other capital types such as profit unrealized, planned earning or the implicit government guarantee. Most banks may use developed internal models to estimate their economic capital. Value-at-risk (VaR) models are more of economic capital (EC) frameworks for credit risk, markets and other risks too. Capital has become a very scarce resource in the credit crisis globally. The management of capital is foremost driven by some risks. Risks in an organization can trigger big losses that deplete the organization’s capital. Therefore banks must consider very carefully the unexpected potential loses which are associated with an individual activity. Businesses that are profitable sufficiently after their consumption of capital are taken into account through maximization of value that requires financing. Economic capital is the best estimate of a bank, of the required capital, absorb losses to a probability of chosen failure. Economic value added (EVA) is the measure of absolute profit amount that an institution earns over its equity cost. Economic capital (EC) models are used to varying degrees with approximately half of the respondents having or owing to an economic-capital model of the bank fully. The role of an economic-capital (EC) is to watch over the unit performance of a business and to ensure that bondholders are safe (ensure their safety). This reduces economic capital by providing a way to overcome or absorb any evident losses. A financial institution that allocates economic capital in its decision making is very much limited by risk management precision. While evaluating the relationships among clients, many institutions distribute their economic capital through counterparty, and only a few individuals aggregate the results to the levels of the country (Tobias et al., 17). A few and already growing number of banks are already relying upon economic capital for its detailed performance and evaluations of transactions. This has accelerated as consensus institution builds on the need to acquire and hold capital against risks that are economic, while all the same returns of earning commensurate this risks. The high, increasing number of insurers all over the world who are trying to implement economic capital (EC), a performance of improved measurement is often stated as the key benefit expected from the implementations. One of the many reasons why economic balance approach sheet is popular in the United States (US), is because it is usually implemented very quickly. Management might expect to earn back a relative return to the risk it still retained, and this drives the value creation of the shareholders. However, capital holding against these risks has associated costs which reduce the creation value. By using an economic capital framework, management can aim to increase shareholder value by decisions relating to the risks it takes on the capital used. Risk-capital-value (RCV) framework focuses on mostly metrics of value-based to measure performance. United States use embedded value (EV) pricing measures. Embedded value is driven off the balance sheet regulatory, with the value of the shareholder contained between the assets that back the regulatory liabilities (Scanlon, 6). The value of liabilities is at most times derived using estimates of best assumptions, by removing all the margins, using consistent discount rates with the risk in the market inherent in the cash flows projected. Distortions are not introduced into a sheet balance by the valuation of regulatory requirements or accounting. Available capital risks are the difference found between liabilities and assets in the economic sheet balance. Under the approach of a consistent market, all associated costs with capital holding are fractional. These frameworks incorporate capital, risk and consistent value basis, and also provides a basis logical for target setting and performance measuring. New performances of business targets need to be linked to the value of a franchise. Value of franchise reflects the expectations of shareholders for new profitability businesses. When the new value of business generated is much lower than expected, the value of the franchise and also shareholders value is destroyed. Policyholders won't be expected to invest in a business with their money that doesn’t hold enough capital. A company will need to hold enough capital to maintain its value of a franchise, but the holding of more was increasing capital frictional costs and thus reduce its value. Essential components of financial institution management are the stable profit generation and the sustenance of portfolio optimal. Management must address various arising risk types from changes in the environment of a business as well as volatilities of financial markets and economic conditions (Willsher, 17). Financial institutions must maintain a very high public confidence level by reliable service provision and financial sounding maintenance. When a bank sets up a Risk Management Committee, the committee allows the top management of the bank to address relating important issues to a framework of risk management and adequacy of capital. Economic capital is very important because it provides answers to key concerns to specific decisions of businesses and also by evaluating the different units of a business or a bank. Economic capital also provides the comparison with regulatory capital. Economic capital based on the making of decisions has recently been experiencing banking revival. A huge number of institutions are improving the sophistication of the existing ones or developing new frameworks. Embedding Risk Management and Economic capital model must be an integral part of the process of making decisions and management culture of an institution for its growth. Economic capital value is therefore very important in the risk management of an organization in various more ways. Work Cited Baer, Tobias, Amit Mehta, and Hamid Samandari. "The use of economic capital in performance management for banks: A perspective." McKinsey & Company (2011). Barrieu, Pauline, and Claudia Ravanelli. "Robust Capital Requirements With Model Risk." Economic Notes 44.1 (2014): 1-28. Web. Scanlon, Mark J. "Performance Measurement within an Economic Capital Framework." Risk Management 3 (2008). Willsher, Richard. "Documentation Risk." Export Finance. Palgrave Macmillan UK, 1995. 148-150. Read More