Note available here.
Many financial institutions (either credit insurers or banks) employ credit limits that are based on par value or Exposure at default (EAD). These have the significant drawback that they are only risk sensitive if numerous limit categories are introduced that distinguish between ratings, maturities and asset classes. The resulting limit system is often complicated, lacking in transparency and difficult to implement effectively.
The alternative is to base limits on the capital consumption of sets of exposure. Limits of this type allow, in a convincing manner, for the relative riskiness of different exposures. They also enable financial institutions to allocate ‘capital budgets’ to different business departments, facilitating corporate planning and business plan realisation.
The challenge in basing limit systems on capital consumption is to solve the IT integration issues that it raises. For many institutions, limits are evaluated in large software systems primarily designed as Core Banking, Core Underwriting, Dealing or Loan Origination systems. These systems often have little scope for bespoke modification and may not be designed to host complex calculations such as those required to evaluate capital.
To cope with these problems, one may devise connector software that links the system evaluating limits with a calculation module which computes either Regulatory or Economic Capital. Commonly, either Regulatory or Economic Capital computations cannot be performed for single exposures alone. For example, Basel II capital requires a concentration adjustment calculation which involves assessing the capital for the entire portfolio. Economic Capital as generated by a Monte Carlo, Credit Portfolio Model (CPM), generally involves simulating a full portfolio of exposures even to evaluate the capital contribution of a single additional exposure.
This note explains some innovative approaches developed by Risk Control that help to resolve these challenges. It describes how Risk Control’s own software, RC-Limit System, may be integrated with a powerful Credit Portfolio Model, RC-Capital Model, to permit the use of Economic Capital-based credit limits. The approach is built around (i) a Connector Application which sits between the two primary systems, facilitating their communication, and (ii) use of a highly efficient proprietary algorithm for calculating the capital consumption of individual exposures called Deal Analysis.