June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 27 of 92 displayed for time periods T+0 through T+7, and how those earnings affect equity. Assume for the moment that T+8 through T+30 have positive earnings expectations, resulting in a significantly positive NPV. Relying on an NPV analysis to determine the economic capital required for market risk, could result overlooking discreet time periods that could erode equity and prevent the company from realizing its full NPV. In this example in time periods T+3 through T+5, the expected earnings are negative, at T+5 resulting in a complete erosion of equity. The potential bankruptcy that could result at T+5 could prevent this company from realizing its full NPV potential. Discounting all potential future earnings to a present value and creating a distribution around that value can potentially cover up time periods, such as T+3 through T+5 in Figure 3.7, that could wipe out remaining equity. Additional benefits of analyzing earnings in this manner include: • Allowing users to better analyze the visible portion of the curve as it relates to earnings, instead of lumping visible with non-visible portion of the curve. • Allows for alignment of Risk Capital requirements from a timing perspective. For example, if the Credit Risk Capital requirement was calculated at a one year time frame, it can be aligned with a one year Market Risk Capital requirement. Keep in mind that the earnings represented in the Figure 3.6 are “expected” earnings. For each one of those earnings bars there is a distribution of potential earnings outcomes, and the elements required to produce those distributions are key aspects to the Capital Adequacy Framework. The first step, of course, is establishing what the earnings expectations are. 3.2.4. Establish Earnings Expectations This is an important juncture where the Risk function and Finance function can intersect. The Finance group is traditionally responsible for determining targets for earnings, earnings per share, and cash flow projections, and utilizing those targets for Figure 3.7 Equity & Earnings Earnings Equity T+0 T+1 T+2 T+3 T+4 T+5 T+6 T+7 Equity Depleted Possible Bankruptcy Equity Growth