Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. vi between companies. Once again, it is as important to understand “how” the companies are going about this measurement as it is to understand the “results” they are calculating. We also discuss mitigation techniques for controlling operative risk. Three Methods for Aggregating Market, Credit, and Operative Risks Finally, this paper outlines steps to combine market, credit, and operative risk to calculate total economic capital. We provide three methodologies (Simple Sum, Modern Portfolio Theory, and Monte Carlo Simulation) for aggregation. The first two methods imply a two-step process. First, the components of economic capital are calculated for each risk. Second, they are aggregated in an analytical form. While these approaches may seem simplistic, they are a practical necessity. The second methodology takes into account the correlation between risk buckets. However, estimating correlation at this level is difficult because of the limited availability of data. Finally, the third methodology attempts to produce a joint probability distribution for the three risk buckets through simulation. This methodology is the most comprehensive and consistent, but is the most costly and most difficult to implement. Financial Liquidity The CCRO recommends calculating liquidity adequacy by measuring internal funding requirements from all expected internal and external financial resources in meeting cash flow obligations or demands under normal and adverse market conditions, taking into account market, credit, and operative contingencies. Modeling liquidity is complex in that it is centered on unexpected change or variation in requirements. To the extent possible, it applies the consistent price propagation or price modeling process used in market and credit risk assessments combined with financial relationships used in the construction of forward-looking financial cash flow statements. The CCRO recommends that companies use both expected and extreme stress test scenarios in modeling liquidity requirements and disclose assumptions. We suggest implementing liquidity limits for contingent liquidity requirements as a means to monitor and report on liquidity risk. Finally, the importance of liquidity dictates measuring liquidity over a number of different time horizons. The CCRO suggests calculating both over a short-term horizon (e.g., 30 days, 90 days) and a longer term (e.g., one year). Example To illustrate the capital adequacy framework, this white paper gives an example of the effects of the activities in the framework and of how the value of economic capital and liquidity might be calculated for a small merchant energy portfolio. The example does not describe how the calculations assessing required capital are performed, but rather the effects of specific activities. This example is attached at the end of the white paper and is meant to be a companion document. The goal of the example is to demonstrate how capital needs and liquidity change based on risk management activities for a single asset as well as a portfolio of assets. The net effect of risk management activities across market, credit, and operative risks and the total portfolio are shown.