Risk-based capital and value creation: ensuring stability with risk-based capital insurance

Citation

Sharma, D. (2009), "Risk-based capital and value creation: ensuring stability with risk-based capital insurance", Journal of Risk Finance, Vol. 10 No. 2. https://doi.org/10.1108/jrf.2009.29410baa.002

Risk-based capital and value creation: ensuring stability with risk-based capital insurance

Article Type: Commentary From: The Journal of Risk Finance, Volume 10, Issue 2

Dhruv SharmaArlington, Virginia, USA

Risk-based capital is an idea whose time has come and gone. It is increasingly evident that the financial markets are unpredictable and prone to “turbulence” (Mandelbrot, 2006). It is prudent for financial institutions to protect their lines of business and portfolios from various operational and unexpected risks.

Goals of risk-based capital requirements

The goal of risk-based capital presumably is to protect its owner and ensure the survival of the firm. Although it is clear that “risk retards the accumulation of capital,” it is also true that risk and reward go hand in hand (Willett, 1951). Thus, allocation of risk-based capital is a necessity but can reduce profitability for its holder. A firm is responsible for earning adequate returns for its owners on the capital it consumes. Keeping risk-based capital increases the firm’s capital, and since it is kept un-invested, it destroys value. Of course, its value is in ensuring the firm’s survival.

A multi-objective optimization problem

Thus, the current problem of allocating the appropriate amount of risk-based capital is a multi-objective trade-off optimization problem with two competing goals: shareholder wealth maximization and assuring the soundness and longevity of the firm.

Of course, all financial executives are aware of this trade-off and I suspect the Basel II accord risk-based capital standards were prompted by fears that too much capital would be maintained and thus resulting in value destruction. According to an FDIC study, the changes in the Basel II standards for risk-based capital will result in “large percentage reductions in risk-based capital requirements”(www.fdic.gov/bank/analytical/fyi/2003/120803fyi.html). The FDIC study, entitled “Estimating the Capital Impact of Basel II in the United States”, bases its results on historical losses and the “Basel Committee’s Quantitative Impact Study 3 (QIS-3),” which “showed a 17 percent reduction for credit-risk capital at US banks.”

Figure 1 (labeled “Chart 2”) from the FDIC study shows actual allocation of capital and estimated required capital. This graph shows that firms tend to allocate more money than may be required. Human nature tends to be conservative, but at the same time aggressive managers who wish to maximize value creation will be tempted to hold lower reserves than necessary.

Figure 1

Therefore, ensuring minimal capital requirements has become the first pillar of Basel II (www.clevelandfed.org/Statistics/ppts/LargeBankConference/RiskBaseCapBaselII.PPT).

A new solution

What follows is an idea for creating greater efficiencies and value creation. I believe that minimizing capital requirements should not be a pillar of the Basel II risk-based capital standards. The most important and only objective of risk-based capital allocation should be the survival of the firm and ensuring that investors earn acceptable returns in spite of risks.

The ingredients in the risk-based capital formula are “probability of default (PD), loss given default (LGD), the exposure at default and effective maturity (M)” (www.fdic.gov/bank/analytical/fyi/2003/042103fyi.html). I think the formula should solely be based on LGD under extreme events and should be determined based on “conditional expected values of extreme failure” (Haimes, 2004). I also believe that instead of looking at the risk of various assets and operations, the risk-based capital should be enough to cover the costs of the firm for a series of time periods and be enough to return adequate returns for investors during those periods as well.

Of course, using a conservative measure such as the one I have just described would greatly increase the risk-based capital requirements but also increase the soundness and stability of financial institutions.

Although maintaining adequate funds for risk-based capital results in safety, the capital maintenance could become burdensome as everyone acknowledges. Greater efficiencies and value can be created if the capital can be put to use and the margin of safety it provides be retained.

A proposal for creating value

What follows is a proposal for greater value creation via a market for risk-based capital in which risk is mitigated and transferred resulting in a gain for the various economic entities involved. Instead of actually keeping on hand the full risk-based capital requirements, firms should purchase contracts or insurance policies to provide the firm accessible funds should the reserves be needed. The insurer in turn should charge an appropriate premium so as to be compensated for the risk that various institutions might need to draw on their lines of risk-based based capital. The insurer should in turn raise the capital via securities issued to investors who will earn income, like holders or debt/equities. The insurer can keep the portion of the premiums and provide the investors a pass through of the premiums. In short legislation supporting the creation and adoption of risk-based capital insurance (RBCI) should be created and the insurance industry should create RBCI and securitize the risk. Such a product will benefit the financial institutions purchasing it, the insurers offering it, and the investors who purchase the securitized risk.

This seems to be a natural step in the evolution of financial innovations. I strongly believe that if the insurance industry, financial institutions, and investors come together to create the RBCI business, it will unleash a great deal of value creation for all participants.

Sample axioms for successful RBCI

Assume a one-time, upfront premium denoted by P, and let:

• •

  Capf – amount of freed-up capital from insurance buyer’s balance sheet;

• •

  Req – capital required on hand for buyer to invest freed-up capital;

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  Pd – buyer’s probability of default;

• •

  Ri – buyer’s expected rate of return from investment of freed-up capital;

• •

  Rf – risk-free rate of return;

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  NPV_B[ · ] – buyer’s net-present-value operator;

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  Inv – capital raised from investors who to fund insurance;

• •

  Rinv – investor’s expected rate of return from investment in insurance; and

• •

  NPV_I[ · ] – investor’s net-present-value operator.

Axiom 1

For value creation using RBCI:This means that the cost of the insurance must be less than the rate of return on investment expected from having the ability to invest the capital plus the risk-free rate times the additional capital needed to ensure the new investment is undertaken.

Axiom 2

The premium should exceed or equal the return expected by investors in the insurance.

Axiom 3

The expected value of the return on investment is the premium minus the PD times the full investment amount.

In determining how much capital to allocate, investors can use a rule such as the Kelly criterion, under which one should be willing to invest only the fraction 2(1−Pd)−1 of discretionary wealth when odds are even (Wilcox, 2004).

Given the possibility of a complete loss of investment, investors face risk that is comparable to equities except when Pd is lower than for stocks.

Large-scale applications and additional concerns

An individual loan contract has high risk of loss of 100 percent of investment. Unlike a mortgage there is no collateral. As such, P for one contract should reflect firm specific risks such leverage, stock performance, EBITDA, profit margins and in short counterparty risk. Since incorporating these risks would make the insurance policy impractical three solutions need to be considered. One solution is from the Mortgage industry of creating pools of risk-based insurance contracts, which diversify across firm specific risks. The second solution is to offer levels of insurance for example underwriting only 80 percent of the RBCI and thus requiring the company requesting insurance to maintain minimal reserves to reduce default probability further. The third important consideration is the investment being undertaken by the institution requesting the insurance coverage. The underwriter of the RBCI could also underwrite the investment of the freed-up capital. This is another novel idea where RBCI is engineered to make the additional investment possible. Under this approach investors can share in the upside of the firm not defaulting and earn additional return.

In the case where a firm cannot reinvest the freed-up capital effectively, the RBCI still can be employed if the firm purchasing RBCI pays out the freed-up capital to shareholders as dividends. In this scenario, value creation will occur if shareholders can reinvest the freed-up capital to earn amounts greater than their respective shares of the insurance premium.

Corresponding author

Dhruv Sharma can be contacted at: ds5j@excite.com