June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 23 of 92 can be included in the Market, Credit, and/or Operative risk category through stress testing and scenario analysis. More will be explained as to how one can approach this aspect in Chapter 7, however for the time being assume that the Business risks are captured within the Market, Credit, and Operative risk buckets. A graphical example of evaluating risk capital and equity is provided below. Figure 3.4 displays the following parameters: Equity Component $290 MM Operative Risk Capital $50 MM Credit Risk Capital $100 MM Market Risk Capital $200 MM Total Risk Capital $350MM Risk Capital will be assessed against the Equity to determine whether this company is adequately capitalized or not. In this example, this company has an Economic Capital Shortfall of ($60) MM. This implies that this company is not sufficiently capitalized relative to the risks it faces. However, what this shortfall truly means largely depends on who is evaluating the capital structure. For internal evaluations, this shortfall indicates that this company is at risk of having its equity wiped out if certain risk events occur. From this point actions can be taken to reduce that likelihood, such as reducing the risk exposure or readjusting the debt-equity balance. From an external constituent perspective, this shortfall can be viewed as debt and can be factored into the overall credit analysis as leverage. In other words, assuming the risk events occur, this entity will be required to borrow funds, from the parent or otherwise, to service its capital requirements. With this in mind, external constituents, when evaluating the debt structure, can include the shortfall with debt when calculating such financial health ratios as debt- to-equity and debt-to-total assets. 3.2.1. Aggregation of Risk Capital In the example above, the risk capital components are simply added together, which is referred to as the Simple Sum Method. This is a very conservative approach since it assumes that each risk category achieves its unexpected loss at the same time (i.e. perfect positive correlation). In reality, this case will most likely not occur therefore, it is prudent to build an upper and lower bound of the potential risk capital requirements. Taking the simple sum as the upper bound, the lower bound can be determined utilizing the Modern Portfolio Theory (MPT) by assuming zero correlation Figure 3.4 Capital Adequacy Structure Equity $290 MM Shortfall $60 MM Market Risk $200 MM Credit Risk $100 MM Operative Risk $50 MM