Capital Risk Appetite and Measurement Techniques

How does a bank ensure enough capital for today?

Banks hold capital to absorb unexpected losses because expected losses should be covered by revenue and capital requirements are typically calculated by the risk or finance functions within a bank.

Unexpected losses will occur in the future and by definition the size of these losses cannot be known with any degree of certainty. To predict these losses a bank will rely on historical experience to provide a guide to the future. If banks can access enough good quality, historical data then they can, for any risk type, produce a histogram illustrating frequency and magnitude of loss events. 

They can create a histogram showing total operational risk losses, showing the probability (or frequency) with which monthly losses occurred, ordered by the size of loss. 

They can also create credit risk distributions with expected losses being covered by a credit margin and unexpected losses being covered by capital up to a confidence interval of 99.95% for example. 

Finally, market risk distributions could be developed to make sure that a bank does not have a risk position that could result in losses outside its risk distribution. 

Banks can, and do, develop these models for controlling risk within the bank for day to day risk management.  They can also use the models, at more extreme confidence intervals, to determine how much capital the bank needs.

How do regulatory capital requirements influence bank capital?

Since the Global Financial Crisis, regulators have typically wanted banks to hold more capital than their internal models tell them to hold. Regulators are thinking about the impact of a bank failure on other banks, depositors and the wider economy, whereas banks are more concerned about shareholder value. Therefore regulatory capital requirements can be thought of as defining regulatory capital risk appetite. 

Regulators define the models that can be used to measure capital risk through the Basel Accords. Many banks can use their own models to measure capital risk, however there are rules that must be applied for those models to be acceptable to the regulator. 

To assess credit risk, the models are known as Internal Ratings Based (IRB) models. For market risk they are Internal Models Approach (IMA) models and for operational risk they are Advanced Models Approach (AMA) models. Each of these models is run daily or monthly, depending on the institution, and the outcome is a measure of Risk Weighted Assets, which form the denominator for banks’ regulatory capital ratios, the CET1 ratio, the Tier 1 ratio and the Total Capital ratio.