June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 7 of 92 Overall Economic Capital for the Firm Once analyzed and quantified, these risk categories can be aggregated to yield an economic capital metric for the firm. This aggregation can be characterized as being within two boundaries an upper boundary that assumes perfect correlation between the different risk buckets (simple sum of all the risks) and a lower boundary that assumes a zero correlation between the silos. These are illustrated in the figure XX: The lower boundary in Figure XX includes a diversification effect of $121MM which is derived from the sum of squares method4. This lowers the risk capital and changes the economic capital requirement from a shortfall to a cushion. However, it is likely that the true risk capital number will fall somewhere between these two boundaries due to the fact the true correlation between the risk buckets lies somewhere between zero and one, thus creating some diversification effect. Therefore it is important to be careful in estimating correlations and volatilities across the risk silos in order to improve the accuracy of the risk capital estimate. We discuss these issues in more detail in the sections that follow. 1.5. Revealing Possible Shortfalls at Interim Time Periods We are primarily concerned with risk events that have the potential to reduce the value of the firm’s equity. In order to make an assessment of the potential earnings losses, one must have an estimate of the mean path of future economic earnings. The various risks can then be modeled as a distribution around the mean path. We posit that there is an additional reason for modeling the expected path of economic earnings over time. This is because as we move through time there may be expected market downturns that can erode equity. The firm’s ability to add stockholder value over this time therefore depends on weathering these downturns. 4 To understand the source of the diversification effect when two assets with less than perfect correlation are combined in a single portfolio the reader is referred to any intermediate finance text in investments and portfolio theory. A more ambitious reader can read H. Markowitz’s text 9 19590 on Portfolio selection and the efficient diversification of investments. Economic Equity $290 Market Risk Capital $200 Credit Risk Capital $100 Operative Risk Capital $50 Diversification Effect $121 $60 Capital Shortfall $61 Capital “Cushion” Risk Capital Requirement $350 Economic Equity $290 Market Risk Capital $200 Credit Risk Capital $100 Operative Risk Capital $50 Diversification Effect $121 $60 Capital Shortfall $61 Capital “ Cushion ” Risk Capital Requirement $350