Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 8 1.4.2 Managing Performance Capital adequacy provides many insights into internal management of performance. Capital Cost of a Business Project or Plan This framework for assessing capital adequacy contributes to performance management by bringing to the forefront the risks implicit in a project or business plan. As such, the framework is a useful starting point for eventually assessing a charge for the utilization of capital. While the determination of the cost of capital is beyond the scope of this paper, managing business for value requires that management account for or “charge” the various commercial activities for the capital they use. By explicitly charging for the cost of expected capital requirements and incorporating the cost of risk through a return measure, performance management for risk-adjusted value is possible. Scalable Metrics Managing performance requires metrics that are scalable from the project-specific level to the enterprise-wide level. Risk management best practices promote use of these kinds of metrics for capital allocation and design of risk management controls (e.g., setting the appropriate VaR and/or credit limits). These metrics can be rolled up to accurately represent how various parts of the company fit within established limits and targets. This capital adequacy framework provides such scalable performance metrics. Enterprise-level capital adequacy requirements are often built from the bottom up, using similar calculations at an asset- or project-specific level. This means that risk- adjusted performance metrics are available from the bottom up for any part of the company. Better Management Decisions The capital adequacy framework supports and promotes better decision-making under uncertainty. Management decisions become more aligned with the ability of the company to fund its businesses. Demonstrating these performance management practices lays the foundation for increasing stakeholders’ confidence in the company’s ability to succeed in the face of an uncertain business environment and should result in enhanced credit ratings. Furthermore, the relationship between an entity’s target credit rating and capital requirements should also be considered, given that differences in credit ratings result in different capitalization requirements. The capital adequacy framework is actionable. Consider a company facing capital inadequacy (Figure 5). This capital adequacy framework will help management evaluate the effects of specific corrective actions. Management may consider changing the company’s capital structure (e.g., reduce debt by adding equity) or reducing economic capital requirements by changing the makeup of the business portfolio’s risk profile.