Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. ix TABLE OF CONTENTS I. INTRODUCTION ....................................................................................................................... 1 1.1 The Concept of Capital Adequacy ................................................................................................. 2 1.2 The Components of Capital Adequacy for Economic Value ...................................................... 3 1.2.1 Framework for Assessing Capital Adequacy for Economic Value ................................... 3 1.2.2 Net Assets .................................................................................................................................. 4 1.2.3 Debt ............................................................................................................................................. 4 1.2.4 Economic Capital and Its Components ................................................................................. 4 1.3 The Components of Capital Adequacy for Liquidity .................................................................. 5 1.4 Importance of the Framework for Assessing Capital Adequacy ............................................... 7 1.4.1 Improving Stakeholder Confidence ....................................................................................... 7 1.4.2 Managing Performance ............................................................................................................ 8 1.4.3 Promoting Transparency in the Industry .............................................................................. 9 II. DETERMINING NET ASSETS FOR ECONOMIC VALUE .................................................. 10 2.1 Alternative 1: Net Assets Based on Invested Capital ................................................................ 10 2.2 Alternative 2: Net Assets Based on Estimated Market Value .................................................. 11 III. INTRODUCTION TO COMPONENTS OF ECONOMIC CAPITAL..................................... 13 IV. MARKET RISK......................................................................................................................... 14 4.1 Definition of Market Risk .............................................................................................................. 14 4.2 Measurement of Market Risk ........................................................................................................ 15 4.3 Exposure Mapping ......................................................................................................................... 16 4.4 Definition of Underlying Market Price Variable Movement Processes for Measuring Market Risk .................................................................................................................................................. 16 4.4.1 Closed-Form Analytical Approach ...................................................................................... 16 4.4.2 Monte Carlo Simulation ......................................................................................................... 17 4.5 Measurement of Market Risk – Simulation Approach .............................................................. 20 4.6 Measurement of Market Risk for Trading and Non-trading Activities .................................. 22 4.6.1 Trading Activities ................................................................................................................... 22 4.6.2 Non-trading Activities ........................................................................................................... 24 V. CREDIT RISK ........................................................................................................................... 27 5.1 Definition of Credit Risk ................................................................................................................ 27 5.2 Basic Framework ............................................................................................................................. 28 5.3 Distribution of Portfolio Credit Losses to Calculate Economic Capital.................................. 29 5.3.1 Elements in Generating Portfolio Expected Loss ............................................................... 29 5.3.2 Elements in Generating Portfolio Unexpected Loss .......................................................... 31 5.4 Comparison of Credit Risk Models .............................................................................................. 33 5.5 Alternative Measure as Interim Step ........................................................................................... 34 5.5.1 Computation of capital, given known exposure ....................................................................... 34 5.5.2 Estimation of exposure.................................................................................................................. 35 5.5.3 Estimation of credit risk capital ................................................................................................... 36 VI. OPERATIONAL/OPERATIONS (OPERATIVE) RISK.......................................................... 37 6.1 Introduction to Operative Risk for Energy Industry ................................................................. 37 6.2 Classification of Operative Risk .................................................................................................... 37 6.3 Operative Risk Measurement Techniques .................................................................................. 38