June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 79 of 92 10. APPENDIX A: PRACTICAL APPLICATION 10.1. Utilizing Capital Adequacy Modeling as a Key Management Tool Modeling capital adequacy can be complex due to the vast number of potential economic capital and liquidity demands uniquely faced by any company. Our earlier paper, “Emerging Practices for Capital Adequacy” and this paper delve in to the theory behind capital adequacy. Detailed methods are discussed for determining risk exposure and calculating its components, adequacy for economic value and adequacy for financial liquidity, to determine whether or not the company has the financial strength to support its strategy while simultaneously creating shareholder value and remaining a viable entity. Although the capital adequacy model is a theoretically sound tool for providing a current view of the short-term and long-term financial health of the company, risk managers may encounter doubt from executive management regarding the use of the model for strategic planning. Due to the complicatedness of achieving a common corporate understanding of risks and calculating risk exposures combined with the effort involved in creating and maintaining such a risk-based and fluid model, executive management may tend to want to adhere to the customary financial barometer measures such as debt coverage ratios, NPV, and ROIC. A common problem with such customary financial measures is that consideration for risk is lacking and capital adequacy and liquidity availability in discreet time periods are not apparent. As can be seen by those who are familiar with our earlier paper as well as those reading this paper, advances continue to be made in acceptable and best practices for capital adequacy and the tools used to calculate. To illustrate our premise, we have included an Applications section to show how capital adequacy can be modeled and used as a tool for testing whether or not the company has the financial strength to support strategy changes affecting its risk profile while staying within its defined boundaries for creating value. Defined boundaries may include any financial or risk measure such as debt-to-equity ratio, desired capitalization, value-at-risk parameters, and credit line availability, among others. The Applications section describes a strategic decision analysis issue faced by a hypothetical energy marketing and trading company. The CRO of the company convinces executive management to have the risk management team deploy an agent based modeling technique to simulate the company’s execution of a proposed expansion strategy in order to view the potential effects of the strategy on the capital adequacy requirements of the company.