Capital budgeting plays an important role in allocating resources in enterprises. Through a well-structured process of capital budgeting done by individual divisions, an enterprise can compare the profitability of its divisions, assess the feasibility of new business proposals, decide which projects to expand, construct a corporate portfolio to maximize returns, such as ROA, ROE and RAROC (risk-adjusted return of capital), and minimize risk.
Traditional metrics for capital budgeting include NPV, IRR, payback period, ROI and etc. However, these metrics may provide misleading conclusions for banks[1]. Their biases tend to more severe after the implementation of Basel II, which links bank capital charges with market risk, credit risk and operational risk.
This paper aims to discuss the limitations of traditional metrics for bank capital budgeting and suggest a new framework of capital budgeting for banks to comply with Basel II. The new framework is able to accommodate a wide range of risk measures, consider capital charges required, evaluate funding costs and compare risk-adjusted values of individual divisions and projects. This paper finally discusses how this new framework can be applied to non-bank enterprises in order to enhance their value-based management.
Basel II and Bank Capital Budgeting
Basel II is a new global regulatory standard implemented in 2006, requiring banks to prepare sufficient capitals, mostly comprised of equity, to support their risky business. Under Basel II, capital charges are linked with three risk categories, namely market risk, credit risk and operational risk. All risk exposures are converted to risk-weighted assets. Banks are required maintain a minimum capital adequacy ratio at 8% (i.e. Regulatory capital / Risk-weighted assets > 8%). Currently most banks follow simple methods (standardized approach or others) specified by their bank supervisors to compute capital charges. Some rely on their internal models to estimate risk levels and convert these risk estimates to capital charges with equations specified by their bank supervisors. For all internal models, banks should have rigorous procedures to do backtesting or model validation.
Basel II compliance is not simply computing right risk estimates. To maximize the use of their capitals, banks should think strategically how to allocate capitals to individual divisions and projects. An ideal scenario will be "high profit with low capital charge". It is because regulatory capital is costly. Also, banks cannot easily grow their equity in a pace like what they can do on their asset. Therefore, banks should have an effective capital budgeting process that considers cash flows, capital charges to be required and cost of the capital charges.
Limitations of Traditional Metrics for Banks
NPV and Hurdle Rate
NPV (net present value) approach is always used to make investment decisions. It identifies cash flows and discounts them with a fixed hurdle rate. Projects with positive NPV are desirable. The hurdle rate may be cost of equity, expected ROE, weighted average cost of capital (WACC) or expected ROA. One weaknesses of the NPV approach is that it does not rigorously consider risks and tends to accept projects of high return and high risk. However, those rejected projects may involve less capital charge, provide a desirable RORC and enable banks to diversify their portfolio risk. In fact banks keep enormous AAA-rated assets or other low-risk assets in their portfolios for liquidity management. Briefly speaking, the NPV approach may mislead banks to accept high-risk businesses and to undertake a risk level much higher than what they can afford.
Some banks consider risk-based hurdle rates and link them with beta, a measure of systematic risk. This approach oversimplifies the risk of banks because bank risks are very diverse. To deal with different risks, banks apply a wide range of risk measures, such as PD, LGD, EAD, beta, volatility, VaR, delta, gamma, vega, duration, expected loss, unexpected loss and so on. How can these risk measures be integrated and linked with hurdle rates? There may be no simple answer. The question will become more difficult if a bank project or bank division involves multiple risks.
IRR, ROI and Payback
IRR approach is to compare the annualized return with a specified hurdle rate. Same as NPV approach, IRR approach tends to favor projects of higher returns and these projects are usually of higher risk.
Return on investment (ROI) can be applied to IT projects and new product development, where
ROI = (Gain from Investments - Cost of Investment) / Cost of Investment.
This approach tends to favor projects that generate more revenue but involve less initial investment. ROI approach does not consider risk rigorously.
Payback period is another measure widely used to assess a project. This approach favors projects with shorter investment horizons and contradicts very much the usual asset composition of banks. In practices, banks invest in many long-term assets, such as project finance, leasing, residential mortgage loans and long-term bonds.
From Risks to Capital Charges
Sanwal (2007) summarizes various approaches of corporate portfolio management, in which enterprises should consider a bundle of metrics to make their capital budgeting. However, capital charges for bank capital budgeting are not discussed in details. The issue of capital charges is particularly important after the implementation of Basel II.
Banks are different from other enterprises in terms of business nature, risk nature, asset composition and regulatory standards. To control risk, bank supervisors require banks to measure their risk in more refined ways. There are a wide range of risk measures applied to different assets, products and divisions. In spite of their individual risk profile, bank divisions can now have their risks aggregated under Basel II because risks are finally converted to capital charges. Take treasury division as an example. This division involves market risk, counterparty risk (i.e. credit risk) and operational risk. Its aggregate capital charge is the capital a bank prepares to support its daily operation. Let's consider some hypothetical capital charges shown in Table 1. The division has $500m capital charge in market risk, $200m capital charge in credit risk and $100m in operational risk. It requires $800m to support its daily operation. Suppose that the division earns a net income of $100m per year and has its average capital charge at $800m throughout the year. Then one can calculate return on regulatory capital (RORC) = 12.5%. If the net income and capital charge are actual numbers, the RORC will be a basis of performance appraisal. If they are projected numbers, the RORC will be a basis for internal resources allocation for the next year.
Table 1 Capital Charge of a Treasury Division
Type of Risk | Capital Charge (actual or projected) |
Market risk - related to exposures of treasury and derivatives products
- measured by VaR
| $500m |
Credit Risk - § related to default risk of counterparties in settlements or custodies
- § measured by probability of default, loss given default, exposure at default, aggregate expected loss and aggregate unexpected loss.
| $200m |
Operational Risk - related to internal and external operational events
- measured by probability of occurrence, loss severity, aggregate expected loss and aggregate unexpected loss.
| $100m |
Total Capital Charge | $800m |
Assume: Net Income of the Division = $100m Return on Regulatory Capital (RORC) = $100m / $800m = 12.5% |
Weighted Average Cost of Regulatory Capital (WACRC)
WACC is cornerstone in traditional capital budgeting. Regulatory capital in banks bears cost. Cost of equity and cost of long-term debts can be proxies for the costs involved. Their weights depend on the composition of regulatory capitals. Banks can firstly estimate regulatory capital composition and then compute their weighted average cost of regulatory capital (WACRC). This WACRC can be used in three aspects. First, it is a yardstick for the RORC mentioned above. Second, it is a discount factor for NPV calculation. Third, it helps identify the cost of regulatory capital for each year:
Regulatory Capital Cost in Year j
= Regulatory Capital to be Required in Year j x WACRC
To support individual divisions, a bank should prepare sufficient regulatory capital. Therefore, each division should undertake its own regulatory capital cost and should have this amount shown in its capital budgeting.
Target Regulatory Capital and Economic Capital
The regulatory capital discussed above is not the minimum capital charge. Basel II sets the minimum capital adequacy ratio (CAR) at 8%. In practices, many banks maintain their CAR at 12% to 18%. This means, they prepare more capital than the minimum one. It is assumed that banks are rational in their decision making. The buffer between actual CAR and 8% should reflect additional risks involved or the market expectation on their CAR level. The additional risks, not fully covered in the Basel II capital charge equations, include liquidity risk, interest rate risk, firm size risk, correlation risk, strategic risk, and reputation risk. Typically a small-sized bank is required to maintain a much higher CAR; otherwise, it would have trouble in external credit rating, interbank borrowing and deposit taking. Banks can benchmark with their peers to identify their target CAR. After a target CAR is established, a bank can compute its target regulatory capital as follows:
Target Regulatory Capital = Minimum Regulatory Capital x (Target CAR / 8%)
In the above equation, the minimum regulatory capital is obtained by Basel II capital charge equations that should have considered unexpected loss and expected loss in market risk, credit risk and operation risk. The target regulatory capital can be equal or even higher than economic capital[3], which generally refers to the capital prepared to absorb possible loss estimated with internal models. Under normal circumstances, banks should consider both internal risk levels and the market expectation on their capital adequacy to set their target CAR. In this context, the target regulatory capital is the capital level a bank will prepare for its divisions. It is the actual economic resources for operating a bank business. If banks do not have their own equations for economic capital calculation, the above equation will be a simple and convincing one. Figure 1 summarizes the differences among target regulatory capital, economic capital and minimum regulatory capital.
Figure 1 Target Regulatory Capital, Economic Capital and Minimum Regulatory Capital Target Regulatory Capital (CAR of peers; target CAR; and internal loss estimates) |
Economic Capital (Risk loss estimates based on internal models) |
Minimum Regulatory Capital (CAR= 8%) |
Regulatory Capital Budgeting and NPV
NPV is a popular tool of capital budgeting. With the above procedures, a bank division can project future net cash flows, including revenue, interest cost, operating cost, tax, regulatory capital cost and residual value and etc. Then all net future cash flows are discounted by WACRC. A positive NPV means that the division adds value to the bank. Banks can easily compare the NPV of individual divisions and individual product lines, and identify their best portfolio mix to maximize their bank value.
Risk-based Capital Budgeting for Enterprises
Enterprise risk management is a hot topic in many non-bank enterprises. Methods for risk measurement are available for many types of risk. However, due to lack of regulatory standard, enterprises do not need to consider regulatory capital and its impact on funding cost. Also, they mostly restrict their risk considerations to business risks in capital budgeting. Operational risks, such as system failures, frauds, legal disputes and etc, are excluded in NPV calculation. With less risk considered and inadequate risk premium applied, enterprises likely overstate the values of their projects.
The principle behind Basel II is to encourage banks to measure risk and estimate both their expected loss and unexpected loss. Expected loss will turn out to be realized loss shown in banks' income statements. If it is not fully realized, the remaining amount can be placed in a reserve account. Unexpected loss indicates the possible maximum loss at a confidence level, say 99% to 99.9%. To ensure the stability of banking systems, Basel II requires banks to prepare capitals for the unexpected loss (i.e. the unusual loss). If extreme events occur, a bank will still survive.
Enterprises may follow a similar approach and measure their expected and unexpected loss in capital budgeting. Expected loss should be a direct cost in cash flow projections. The unexpected loss should be the amount of additional equity that enterprises prepare for extreme events. The dollar cost of this additional equity will be size of additional equity multiplied by cost of equity. By considering the expected loss and cost of unexpected loss, enterprises can effectively integrate all risks in their capital budgeting, benchmark the divisional performance, and identify new projects that add risk-adjusted value.
Summary
This article has summarized the limitations of traditional metrics for bank capital budgeting. The adoption of Basel II will enable banks to consider rigorously cost of regulatory capital in their capital budgeting. This article suggests a new framework for bank capital budgeting, which considers target regulatory capital, composition of regulatory capitals, and weighted average cost of regulatory capital. This framework can be modified to suit the needs of non-bank enterprises if they can assess expected loss and unexpected loss in their risk analysis. Traditional capital budgeting methods tends to consider less risk and overstate the value of projects. If risks are effectively included in the capital budgeting process, enterprises will make better decisions in their internal resources allocation, bringing risk-adjusted value to their stakeholders and enhancing heir value-based management.
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Footnotes
[1] This article is based on the author's presentation "Capital Budgeting after Basel II" made in Asia Pacific Convention of Global Association of Risk Professionals in November 2007. [2] Matz and Coulmas (1995) surveyed 55 banks in the USA and found that many banks, around 25%, did not have any systemic procedures to do capital budgeting.
[3] Basel Committee (2006)
[4] So far there is no standard practice on what economic capital means. Some argue that it is the unexpected loss. Some argue that it the capital to absorb possible loss with a certain level of confidence (Helbekkmo 2006). This article argues that target regulatory capital can be used to measure economic capital because it is the actual resources for banks to run their business.
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