Mark Wells, Associate Director of Portfolio Research at Moody’s Analytics, outlines how the parameterization of an Economic Capital model differs for accrual and securities portfolios and relates the parameterization approaches with those associated with Basel Advanced-IRB calculations.
Banks commonly use Risk Contribution, or contribution to portfolio Unexpected Loss (i.e., standard deviation), as a risk allocation method. While the method has some very desirable properties, it can also produce seemingly counterintuitive dynamics, whereby high interest income-producing assets are associated with higher risk, all else being equal. This dynamic manifests from the higher interest income assets possessing higher value, leading to higher standard deviation in absolute terms. In reality, financial institutions often use interest income to offset losses, and thus, associate higher interest with lower risk. This paper introduces a new, income-adjusted form of Risk Contribution-based capital allocation, designed so that interest income offsets losses. The measure demonstrates improved properties for exposures with particularly high coupons.
When parameterizing an Economic Capital (EC) framework, organizations must consider how losses and gains on principal and coupons/fees are recognized, if they are to ensure appropriate capitalization. The level of loss allowance and capital organizations hold must be sufficient to cover potential losses. This paper outlines how parametrization differs for accrual and securities portfolios. In addition, we relate parametrization approaches with those associated with Basel Advanced-IRB calculations. We conclude that, when measuring an organization's required economic capital buffer, the relevant loss reference point is the accounting value net of loss allowance — losses should be measured in excess of total spread. While seemingly inconsistent with the Basel A-IRB formulation, where losses are measured in excess of expected loss, the difference can be interpreted as loss allowance exactly aligning with expected loss.