June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 15 of 92 their own defined set of parameters. By discussing best practice calculation methods for the components themselves, more transparency and consistency in application approaches are documented for calculating risk exposures and providing insight into how companies determine their economic capital requirements. Determining capital adequacy is more than a quantitative exercise. Our previous white paper on the subject demonstrates that aspects of the capital adequacy measure such as market and credit risk can be quantified to some degree while the assessment of operative and business risks are often more qualitative. However, even if risks can be readily quantified, correlation and diversification effects should be considered thereby adding challenges for external quantitative capital adequacy assessments due to varying business and portfolio structures complicating the application of a generic measure. Incorporating both quantitative and qualitative assessments is necessary for determining whether or not a company has adequate capital to support their business initiatives. Capital adequacy assessment methodologies vary by credit rating agency. During the course of writing this paper, we discussed capital adequacy assessment methodologies with some of the credit rating agencies and found that, like other factors considered by the agencies in formulating their issued credit ratings, capital adequacy is not the key determinant of ratings. Similar to how a company should view quantitative capital adequacy measures in conjunction with qualitative aspects, credit rating agencies incorporate into their consideration for capital adequacy both hard exposure calculations and viewpoints on the general risk profile of the company including the current state of the industry, market dynamics, and sophistication and diligence of risk management practices among other factors. The capital adequacy assessment is one of many factors viewed by credit rating agencies in determining ratings. Increasing the transparency of risk exposure calculations and risk assessments combined with deploying well-defined general risk management practices should provide assurances both internally and externally that the company’s management is “risk aware” and appropriately aligning risks with available capital and liquidity. Consequently, this paper focuses on using capital adequacy assessment as a key tool to support and validate strategic decisions. The Application section of this paper exemplifies the use of capital adequacy modeling as an important tool for viewing the effects of new strategies and business initiatives on a company’s economic value and financial liquidity. Understanding the potential risk exposure over time caused by changes to the business model and applying an “equity at risk” perspective aid in determining whether or not the company has the financial wherewithal to support the chosen strategies. In summary, • Capital adequacy is one of many factors viewed by credit ratings agencies in determining ratings. • Ratings agencies deploy both consistently applied quantitative and qualitative methodologies as well as consideration of unique aspects of the business model for assessing a company's capital requirements. • Assessing, monitoring, and modeling capital adequacy is both a useful financial measure and strategic planning tool.