The debtholder's perspective.(Risk, Capital, and Value Measurement in Financial Institutions, part one)

Increasingly sophisticated risk measurement tools have evolved to help financial institutions measure market risk (value-at-risk measurement tools), credit risk (expected and unexpected loss measurement tools), and insurance risk (dynamic financial analysis tools). There also have been advances in using these evolving risk metrics to help guide executive management in their strategic decision-making. The framework through which this is accomplished typically has two parts:

1. Risk is related to the amount of capital the firm requires to achieve a sufficient level of protection against adverse circumstances.

2. Risk is used to adjust the returns from business activities to determine whether activities are value adding or value destroying.

The first part should reflect a debtholder's perspective on risk (Is there sufficient capital to cover "worst case" risks?). The second part should reflect a shareholder's perspective on risk (Are we getting a sufficient return for the systematic risk being taken?).

The debtholder and shareholder views of risk differ but are related. Actions that tend to increase risk for debtholders also tend to increase risk for shareholders. However, in important ways, the views diverge. For example, debtholders value risk diversification at every. level, while shareholders do not value diversification they can replicate on their own. In short, these two constituencies can draw on the same underlying risk measurement framework, but will view the resulting risk measures through different lenses.

A Conceptual Framework for Attributing Capital

The first step in attributing capital is developing a theoretical framework for relating risk to the amount of capital a financial institution needs to hold. Many financial institutions have developed a framework based on Merton's model of default(1). This model effectively assumes the following:

* Shareholders own the right to default on debtholders and will do so if the value of the firm's equity (or "net assets") drops to zero.

* Debtholders charge shareholders for default risk by demanding a spread over the risk-free rate on the funds they provide.

* The probability of default is a function of the firm's net asset value distribution and its current net asset value

The last element of the above approach can be inverted. That is, a theoretically robust estimate of required capital can be determined if the net asset value distribution is known and a probability of default (or solvency standard) is selected.

Common Pitfalls

Most financial institutions have developed methods for relating risk to capital which, on the surface, look similar to the framework described above. However, there are …