Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 43 VII. COMBINING MARKET, CREDIT AND OPERATIVE ECONOMIC CAPITAL As stated, the primary objective of this white paper is to quantify the risk of a company’s business over a desired time horizon in the single metric of economic capital. After completing the analysis of the individual components of market, credit, operations, and operational risks, the next step is to combine them. Total economic capital is the result of combining all individual risk components. By comparing total economic capital with the amount of equity and other balance sheet items, we can assess the capital adequacy of an organization. 7.1 Framework The framework of the combined risk capital should abide by sound risk management practices while recognizing the inherent difficulties of combining risk buckets. The framework should be transparent, practical, consistent, and provide the right incentives. The framework should be easily understood throughout the corporation. Transparency is reflected in a clear definition of input parameters, methodology, and characterization of outputs. Section 7.2 discusses the choice of time horizon and confidence level. Section 7.3 presents the different modeling solutions. Details about energy risk simulation models are given in Sections 4 and 5 above. Section 7.4 discusses the strengths and weaknesses of the methodologies. The methodological solutions below are presented in increasing order of sophistication. The first two methods imply a two-step process. First, using the Simple Sum method, the components of economic capital are calculated for each risk bucket and then aggregated in an analytical form. While these steps may seem simplistic and may lead to inconsistencies (because of the modeling differences across risk buckets), they are easy to implement and are viewed as a practical necessity. The second methodology, Modern Portfolio Theory, takes into account the correlation between risk buckets. Estimating correlation at this level is difficult, however, because of the limited data available. Finally, the third methodology, Monte Carlo simulation, attempts to produce a joint probability distribution for the three risk buckets through one simulation engine. This methodology is the most comprehensive and consistent but is also the most costly and the least practical. Throughout this white paper, we recommend using consistent inputs as much as possible. Therefore, if a market price simulation model is developed, it should be used for all the risk buckets as appropriate. Similarly, the confidence level and time horizon should be consistent across the risk buckets and in line with the company’s risk appetite. While the combined model strives for consistency, it also reflects the idiosyncratic mix of model sophistication across risk buckets. As indicated in other sections, the level of development of the models for the three risk buckets differs strongly. Market and credit risks are quantified with fairly robust models while operative risk models are still in their infancy. Corporations will need to decide on the tradeoff between accuracy and consistency: Should the accuracy of the Monte Carlo