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October 2016

Pierre Xu, Associate Director of Portfolio Research at Moody’s Analytics will discuss how required economic capital (EC) accounts for economic risks such as diversification and concentration effects.

During recent years, higher capital standards imposed by new stress testing requirements have forced organizations to address how to better manage capital to meet regulatory constraints. While maintaining higher capital levels is indeed mandatory, simply satisfying the requirement does not necessarily align with stakeholders’ preferences for optimal capital deployment and investment decisions.
Related Insights

A Composite Capital Allocation Measure Integrating Regulatory and Economic Capital, and the Impact of IFRS 9 and CECL

We propose a composite capital allocation measure integrating regulatory and economic capital. The approach builds upon the economic framework underpinning traditional RORAC-style business decision rules, allowing for an optimized risk-return tradeoff while adhering to regulatory capital constraints. The measure has a number of depictions, and it can be viewed as a weighted sum of economic and regulatory capital, as economic capital adjusted for a regulatory capital charge, or as regulatory capital adjusted for concentration risk and diversification benefits. Intuitively, when represented as economic capital adjusted for a regulatory capital charge, the adjustment can be represented as the additional top-of-the-house regulatory capital, above economic capital, allocated by each instrument's required regulatory capital. We show that the measure has ideal properties for an integrated capital measure. When regulatory capital is binding, composite capital aggregates to the institution's top-of-the-house target capitalization rate. We find the measure is higher than economic capital, but lower than regulatory capital for instruments with high credit quality, reflecting the high regulatory capital charge for this instrument class. Finally, we address how IFRS 9/CECL impacts the CCM and discuss the broader implications of the new accounting standards.

May 2017 Pdf Dr. Amnon Levy, Dr. Pierre Xu

What Do 20 Million C&I Loan Observations Say about New Origination Dynamics? — Insights from Moody's Analytics CRD Data

We construct and examine new origination of C&I loans to middle-market borrowers using the Loan Accounting System data extracted from Moody's Analytics Credit Research Database (CRD/LAS). We find that C&I loan origination declines during the Great Recession and recovers soon after. The magnitude of the decline and the speed of the recovery varies across segments. For example, new lending to the financial industry decreases more than to the non-financial industry during the recession and recovers faster afterwards. Another example, new originations during the recession consists predominantly of short-term loans, while long-term lending becomes more dominant post crisis. This finding suggests that banks are using loan tenor as a means to mitigate risk during crises, at times even more so than credit quality.

February 2017 Pdf Dr. Pierre Xu, Tomer Yahalom, May Jeng

Measuring and Managing Credit Earnings Volatility of a Loan Portfolio Under IFRS 9

IFRS 9 materially changes how institutions set aside loss allowance. With allowances flowing into earnings, the new rules can have dramatic effects on earnings volatility. In this paper, we propose general methodologies to measure and manage credit earnings volatility of a loan portfolio under IFRS 9. We walk through IFRS 9 rules and the different mechanisms that it interacts with which flow into earnings dynamics. We demonstrate that earnings will be impacted significantly by credit migration under IFRS 9. In addition, the increased sensitivity to migration will be further compounded by the impact of correlation and concentration. We propose a modeling framework that measures portfolio credit earnings volatility and discuss several metrics that can be used to better manage earnings risk.

January 2017 Pdf Dr. Amnon LevyDr. Yanping PanDr. Yashan Wang, Dr. Pierre Xu, Dr. Jing Zhang, Xuan Liang

Quantitative Research Webinar Series: The Degree Regulatory Capital is Constraining and Impact on Investment Decision Rules

As the techniques and software that underpin Internal Models have matured, the next wave of Internal Model firms can benefit from faster implementations and reduced costs, with off-the-shelf solutions that have been designed to meet the demands of a simulation-based Internal Model.

October 2016 WebPage Dr. Pierre Xu

Managing Earnings Volatility and Uncertainty in the Supply and Demand for Regulatory Capital: The Impact of IFRS 9

This paper presents a novel modeling approach that allows for better management of the interplay between supply and demand dynamics for regulatory capital, combining an economic framework with regulatory capital and new loss recognition rules. The framework is particularly relevant in understanding the extent to which IFRS 9 can lead to more aggressive provisioning, which feeds into earnings volatility. Our approach provides guidance on how organizations can better manage their capital buffer, considering investment concentration, its impact on earnings volatility, and the relationship with regulatory capital requirements. Imperative to portfolio management, the framework recognizes the likelihood of a capital shortfall being significantly impacted by portfolio asset class, geography, industry, and name concentration, as extreme fluctuations in capital supply and demand occur more often for institutions holding more concentrated portfolios. Finally, we discuss integrated investment and strategic decision measures that account for the full spectrum of economic risks and interactions with regulatory and accounting rules, as well as instruments' contribution to earnings volatility and capital surplus dynamics.

September 2016 Pdf Dr. Amnon Levy, Dr. Pierre Xu, Dr. Jing Zhang, Andriy Protsyk

Quantitative Research Webinar Series: The Degree to Which Regulatory Capital is Constraining and the Impact on Investment Decision Rules

Prudent risk management needs to account for both the regulatory capital requirement faced by the institution and the intrinsic risk of the portfolio. The Composite Capital Measure helps risk managers to allocate capital and make investment decisions accordingly.

August 2016 WebPage Dr. Pierre Xu

Investment Decisions and Risk-Based Capital Allocation Under Stress Testing Requirements

Higher capital standards imposed by new stress testing requirements have forced organizations to address how to better manage capital to meet regulatory constraints. While maintaining higher capital levels is indeed mandatory, simply satisfying the requirement does not necessarily align with stakeholders' preferences for optimal capital deployment and investment decisions. CCAR-style stress tests are requirements that organizations must adhere to; however, these exercises likely do not reflect how stakeholders actually trade off risk and return.

May 2016 Pdf Dr. Amnon Levy, Dr. Pierre Xu

Credit Risk Management Under Regulatory Capital Constraints

This article outlines recent approaches to managing credit risk when facing regulatory capital requirements. We explore how institutions should best allocate capital and make economically-optimized investment decisions under regulatory capital constraints, such as those imposed by Basel or CCAR-style rules.

December 2015 WebPage Dr. Amnon Levy, Dr. Pierre Xu, Dr. Jing Zhang

Practical Considerations When Unifying Regulatory and Economic Capital in Investment Decisions

The degree to which an organization's regulatory capital is constraining impacts an investment's appeal. The more constraint on the organization, the more heavily an instrument's regulatory capital weighs down the investment's appeal, with investments assigned higher regulatory capital impacted more. This paper explores a method for measuring the extent to which an organization's regulatory capital binds and calibrates the model introduced by Levy, Kaplin, Meng, and Zhang (2012), which unifies regulatory and economic capital in investment decisions. We then examine the impact of the regulatory capital requirement on investment decisions based on the calibrated model. We find that the rank order of exposures' risk-return tradeoff in our sample portfolio changes substantially when taking into account the regulatory capital constraint.

August 2015 Pdf Dr. Pierre Xu, Dr. Amnon Levy, Qiang Meng, Andrew Kaplin