Overview: The idea is simply creating a market for risk based capital policies which banks/insurers buy and pay a premium for from the issuer. If the company needs money all of a sudden then the policy can be cashed in like insurance. The benefit of this is that banks and insurance companies needing risk based capital reserves don't have to literally have the money on their books tied up doing nothing. Instead a smaller fraction of necessary risk based capital can be held and the remanining portion can be purchased in the form of risk based capital insurance. Models to determine optimal amount of money to keep in hand and the how to underwrite this insurance policy need to be developed. Also a new company of third party needs to be created to offer this product to insurance and bank companies as they companies should not lend to each other directly or themselves.This is the gist of the idea. Below is a mini essay I wrote on it.Dhruv S.

Risk Based Capital is an idea whose time has come and gone. It is increasingly evident that the financial markets are unpredictable and prone to “turbulence” . It is prudent for financial institutions to protect their lines of business and portfolios from various operational and unexpected risks.

The goal of risk-based capital presumably is to protect its owner and ensure the survival of the firm. Although it is clear that ‘risk retards the accumulation of capital,’ it is also true that risk and reward go hand in hand. Thus, allocation of risk-based capital is a necessity but can reduce profitability for its holder. A firm is responsible for earning adequate returns for its owners on the capital it consumes. Keeping risk-based capital increases the firm’s capital, and since it is kept un-invested, it destroys value. Of course, its value is in ensuring the firm’s survival.

Thus, the current problem of allocating the appropriate amount of risk-based capital is a multi-objective tradeoff optimization problem with 2 competing goals: Shareholder wealth maximization and assuring the soundness and longevity of the firm.

Of course, all financial executives are aware of this trade-off and I suspect the Basel II accord risk-based capital standards were prompted by fears that too much capital would be maintained and thus resulting in value destruction. According to an FDIC study, the changes in the Basel II standards for risk-based capital will result in “large percentage reductions in risk-based capital requirements “. The FDIC study entitled Estimating the Capital Impact of Basel II in the United States bases their results on historical losses and ‘Basel Committee's Quantitative Impact Study 3 (QIS-3)’ which ‘showed a 17 percent reduction for credit-risk capital at U.S. banks’.

This chart from the FDIC study shows actual allocation of capital and estimated required capital. This graph shows that firms tend to allocate more money than may be required. Human nature tends to be conservative, but at the same time aggressive managers who wish to maximize value creation will be tempted to hold lower reserves than necessary.Therefore ensuring minimal capital requirements has become the first pillar of Basel II.

What follows is an idea for creating greater efficiencies and value creation. I believe that minimizing capital requirements should not be a pillar of the Basel II risk-based capital standards. The most important and only objective of risk-based capital allocation should be the survival of the firm and ensuring that investors earn acceptable returns in spite of risks.

The ingredients in the risk-based capital formula are “probability of default (PD), loss given default (LGD), the exposure at default (EAD) and effective maturity (M) “ I think the formula should solely be based on loss given default under extreme events and should be determined based on ‘conditional expected values of extreme failure’. I also believe that instead of looking at the risk of various assets and operations, the risk-based capital should be enough to cover the costs of the firm for a series of time periods and be enough to return adequate returns for investors during those periods as well.

Of course using a conservative measure such as the one I have just described would greatly increase the risk-based capital requirements but also increase the soundness and stability of financial institutions.

Although maintaining adequate funds for risk-based capital results in safety, the capital maintenance could become burdensome as everyone acknowledges. Greater efficiencies and value can be created if the capital can be put to use and the margin of safety it provides be retained.

What follows is a proposal for greater value creation via a market for risk-based capital in which risk is mitigated and transferred resulting in a gain for the various economic entities involved. Instead of actually keeping on hand the full risk-based capital requirements, firms should purchase contracts or insurance policies to provide the firm accessible funds should the reserves be needed. The insurer in turn should charge an appropriate premium so as to be compensated for the risk that various institutions might need to draw on their lines of risk-based based capital. The insurer should in turn raise the capital via securities issued to investors who will earn income, like holders or debt/equities. The insurer can keep the portion of the premiums and provide the investors a pass through of the premiums. In short legislation supporting the creation and adoption of risk-based capital insurance should be created and the insurance industry should create risk based capital insurance and securitize the risk. Such a product will benefit the financial institutions purchasing it, the insurers offering it, and the investors who purchase the securitized risk.

This seems to be a natural step in the evolution of financial innovations. I strongly believe that if the insurance industry, financial institutions, and investors come together to create the risk-based capital insurance business, it will unleash a great deal of value creation for all participants.

Risk based capital standard can be focused on financial soundness rather than the minimization of capital, which is a suspect first pillar for any risk based management program. Further research on the creation of underwriting standards for risk based capital insurance and legal and industry corroboration is needed.

Additional Resources:

http://scholar.google.com/url?sa=U&q=http://www.federalreserve.gov/pubs/feds/2001/200160/200160pap.pdf

http://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.html

http://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.htmlhttp://rmtf.soa.org/rmtf_rbcc.htmlstat.ustc.edu.cn/data/paper/RBC.ppt www.ofheo.gov/media/pdf/FREcapclass6302005.pdf

www.clevelandfed.org/Statistics/ ppts/LargeBankConference/RiskBaseCapBaselII.PPT -www.naic.org/frs/rbc/docs/RBCoverview.pdf www.milliman.com/pubs/HRR29.pdf www.sbaer.uca.edu/research/ssbia/1992/pdf/04.pdf cba.ualr.edu/jrhall/17-capital%20management.ppt fisher.osu.edu/fin/autumn2004/ 826/Capital%20Adequacy.ppt www.law.harvard.edu/programs/ pifs/pdfs/colloquium_agenda.pdfwww.state.nd.us/lr/cencode/t261c032.pdf http://www.defaultrisk.com/pp_super_01.htmhttp://www.ofheo.gov/media/pdf/RBCSimApp.htmlwww.sbgo.com/Papers/fmp-v1i2.pdf

http://www.fdic.gov/bank/analytical/fyi/2003/120803fyi.htmlhttp://www.fdic.gov/bank/analytical/fyi/2003/042103fyi.htmlhttp://www.naic.org/insprod/jir/http://www.occ.treas.gov/rbc.htm

Risk-Based Capital Standards and the Riskiness of Bank Portfolios: Credit and Factor Risk by Steven R. Grenalier of Stanford University, andBrian J. Hall of Harvard University

OFHEO’s Final Risk-Based Capital Regulation* July 19, 2001

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