June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 26 of 92 Whether one has chosen to aggregate using simple sum, zero correlations, or some other correlations between the risk types, once an aggregated risk capital requirement has been determined it is prudent to include an equity “cushion” that provides additional capital should the equity depleting risk events occur. Should these equity eroding risk events become realized, a company will still need sufficient capital on hand to continue operations and provide collateral to lenders of last resort. For instance, from the example above the simple sum Risk Capital Requirement was $350 MM. If the risk events were to occur and the $350 MM loss to equity realized, the company would need sufficient equity to recover from this loss, still be able to provide collateral to lenders, and retain enough equity for future growth opportunities. The “cushion” should be based on the amount of Equity a company feels comfortable maintaining subsequent to the risk events becoming realized. Figure 3.6 illustrates this concept. 3.2.3. The Time Component Also, when aggregating the risk capital requirements from the various risk buckets, it is important to ensure that the time component is consistent when measuring each risk capital component. For example, if the Credit Risk Capital requirement is based on Credit metrics that cover a 1 year time period, it is prudent to ensure that the Market and Operative Risk Requirements also are risks faced within the same 1 year time period. When assessing how far out to look in your forward view in assessing adequate capital and liquidity, one should analyze as far out as data and capabilities permit, whether that is one year out, five years out, or longer. Individual companies should decide how long or short the time component of the risk capital requirement is analyzed, depending on the integrity of the data they have, the capabilities they posses, and how they internally manage risk. Recall once again Figure 3.1, where the risk capital requirement is assessed against equity in order to ascertain the capital adequacy of the company. We are primarily concerned with risk events that have the potential to reduce the amount of equity in the company (i.e. when there are earnings losses). In order to make the assessment of what potential earnings losses exist, one must make an assumption of what future earnings will be. In so doing, it is important to view discreet time periods as there may be expected market downturns that will erode equity. However, if these downturns can be weathered it can result in equity enhancement (i.e. positive NPV). For example, Figure 3.7 demonstrates how earnings can enhance or degrade a company’s equity. In this example, the earnings expectations for a company are Figure 3.6 The Equity “Cushion” Operative Risk Capital Requirements Credit Risk Capital Requirements Market Risk Capital Requirements Equity “Cushion”