Economic capital
EC is the amount of capital that NIBC allocates as a buffer against potential losses from business activities, based upon its 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 EC of each business to its profit results in the calculation of its RAROC. EC and RAROC are key tools used in support of the capital allocation process according to which shareholders’ equity is allocated as efficiently as possible based on expectations of both risk and return. The usage of EC is reported once every two weeks to the ALCO. The ALCO resets the maximum allocation level of EC to and within each business, taking into account business expectations and the desired risk profile. EC 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 0.01% that losses in a period of one year will be larger than the allocated EC.
EC methodology
NIBC uses the business model of each activity as the basis for determining the EC approach. If the business model of an activity is trading, distribution, or investment for a limited period of time, a market risk approach is used based upon VaR and scaled to a one-year horizon to calculate the EC 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 EC for business risk, reputation risk and model risk on a group-wide level.
The EC 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 EC 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 EC are therefore monitored accordingly.
The main differences between the EC and regulatory capital framework exist for the Residential Mortgage portfolio, the European Securitisations portfolio as investor and NIBC’s interest rate mismatch position. EC 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 securitisations) or not included at all within Basel II Pillar 1 (mismatch position). As the EC methodology may differ significantly among financial institutions, it is more appropriate to compare the regulatory capital figures in note 57 to the consolidated financial statements for the purpose of industry comparison of market risk and credit risk exposures.
EC Usage
EC is allocated to all business activities in the form of limits set by the ALCO. The amount of EC usage of each business in then calculated, based on the risk of its activities.
- For the Corporate Loan portfolio, which uses a major part of EC, EC usage is calculated using a credit risk approach based upon the Basel II regulatory capital formula and an add-on for concentration risk;
- For the Debt Investments and Trading portfolios, Residential Mortgage portfolio and the interest rate mismatch position, a market risk approach is used to determine EC usage. EC usage for these portfolios is calculated using VaR, calculated with four years of historical data and scaled to a one-year horizon;
- For the Investment Management Loan portfolio, EC usage is calculated by applying a credit risk approach based upon the Basel II regulatory capital formula; and
- For the Equity Investment portfolio, fixed percentages are used.
Table 29 shows the EC usage per business activity. In its Market Risk EC calculation, NIBC takes diversification effects into account between credit spread and interest rate risk. Diversification occurs through the fact that not all risks will occur at the same time. Therefore, the sum of EC for these market risks on a stand-alone basis will be higher than the amount of EC if these risks are combined. This reduction of EC is defined as diversification. The EC framework does not take into account diversification effects between the different risk categories (credit, market and operational risk).
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Table 29 Economic capital per business activity |
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in EUR millions |
31 December 2009 |
31 December 2008 |
Difference (in %) |
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|
Corporate Loan portfolio |
493 |
428 |
15 |
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|
Residential Mortgage portfolio |
262 |
280 |
(6) |
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|
Debt Investments and Trading portfolio |
340 |
241 |
41 |
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|
Investment Management Loans and Equity Investments portfolio |
185 |
201 |
(8) |
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|
Interest Rate Mismatch portfolio |
252 |
122 |
107 |
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|
Operational risk |
71 |
95 |
(26) |
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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 |
1,823 |
1,585 |
15 |
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|
Diversification effect |
(306) |
(295) |
4 |
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Total economic capital usage net of diversification effect at 31 December |
1,518 |
1,290 |
18 |
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The changes in the usage of EC at year-end 2009 are due to a variety of factors. The increase of 15% noted for the Corporate Loan portfolio was the result of downward rating migrations in the portfolio, as well as an increase in the size of the portfolio.
The usage of the Residential Mortgage portfolio declined by 6%, due to a limited decrease in the size of this portfolio.
Furthermore, the EC usage of the Debt Investments and Trading portfolios increased by 41%, because of a higher valuation of assets resulting from credit spread tightening, and the establishment of a short-term liquidity portfolio that relates to the cash surplus of NIBC.
A decrease of 8% was noted for the portfolios of Investment Management loans and equity investments, due to revaluations and impairments.
Lastly, the EC usage of the interest rate mismatch position increased by 107%, because of the re-establishment of strategic mismatch positions by NIBC.
