Capital Allocation Strategies - Risk 2014, Dubai UAE


Published on

Capital Allocation considerations given the recent changes in the regulatory landscape in financial services

Published in: Business, Economy & Finance
  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Capital Allocation Strategies - Risk 2014, Dubai UAE

  1. 1. Optimizing Capital Allocation Strategies Tarun Dara, Mubadala GE Capital Confidential
  2. 2. Efficient use of scarce resources Land, Labour and “Capital”….. - Adam Smith (Wealth of Nations in 1776) Confidential 2
  3. 3. Preface Confidential 3 Understand stakeholders & their expectations1 Considerations for Capital Management2 Elements in Risk-Adjusted Return Framework3 Capital Allocation Framework and Strategies4
  4. 4. Stakeholders of Capital Confidential 4 SHAREHOLDERS consideration is to maximize value creation in form of dividend and growth optimize capital BONDHOLDERS consideration is likelihood of repayment of principal and interest risk of default REGULATORS consideration is capital adequacy, stressed outcomes gradually trending towards risk-sensitive capital measures RATING AGENCIES consideration is on capital strength, economic capital risk & capital management framework 1
  5. 5. Challenges at the Board Level Confidential 5 • How much capital is required to support the various risks in my business ? How does this compare to regulatory and rating agency capital constraints ? • What returns should we be/are we getting on that capital ? • Are the various business segments/individual investments meeting the threshold returns ? What does this tell us about how we should allocate capital and resources ? 1
  6. 6. Multiple measures of Capital Confidential 6 Economic Capital (EC) Accounts for diversification and concentration risk, facilitates strategic planning, limit setting, as well as defining risk appetite Regulatory Capital (RegC) Binding constraint, change in portfolio composition can require drastic action…sale of business unit, access capital markets at unfavorable terms Regulatory Stress Test Capital (RSTC) Advent of recent regulations, FI’s face constraints that are increasingly impacting investment decisions Is there a need for unified measure…EC, RegC & RSTC ? Should all influence decision making ? 2
  7. 7. Capital Framework Confidential 7 Risk Vs. Capital Capital Protection Risk Vs. Reward Capital Development • Aligning Book Capital, Regulatory & Economic Capital • Using Economic Capital to set limits • Stress Testing and Scenario Analysis • Rating Strategy • Integrating Economic Capital in Strategic Planning Processes • Risk-adjusted Pricing • Risk-adjusted performance management • Optimization and active credit portfolio management Business Benefits (Economic Security) Business Benefits (Safeguard Profitability) DEBT HOLDER’S PERSPECTIVE SHAREHOLDER’S PERSPECTIVE 2
  8. 8. Risk-Adjusted Return Framework Confidential 8 Income - Operating Expenses – Expected Loss + Capital Benefit Economic Capital EVA = A Risk-Adjusted Performance Measurement (RAPM) links risk (the amount of economic capital consumed) with returns (the risk –adjusted returns adjusted). RAROC = Risk Adjusted Return – (Economic Capital x Hurdle Rate) 3
  9. 9. • Probability of Default Within 1 year • Default = Bankruptcy, 90 Days Past Due, Restructuring to Avoid Default • Economic Losses Post Default • Includes All Costs, Timing of Recoveries • Function Of Collateral, Seniority • Expected Size of Exposure at Default • Need to model for Revolvers & for other unfunded commitments • “Cost Of Doing Business” • Given Predictable, not “Risk” per se • Typically reflected in Pricing Probability of Default Loss Given Default Exposure At Default Expected Losses = X X Expected Loss Confidential 9 3
  10. 10. • Economic Capital (Ecap) is the amount of capital a business or product require, for a given amount of risk, to achieve a specified level of confidence that an extreme loss will not exceed the capital • Measured as the potential loss in excess of EL over one year time period at a specified confidence level or criterion • Represents comprehensive risk measurement which can be thought of as “unit of risk” Economic Capital Confidential 10 3
  11. 11. Economic Capital is Provided to Cover Extreme or “Tail Risk” Events EL Probability of a “Tail Risk” Event is a function of Unexpected Loss (Volatility) Expected Loss Vs. Unexpected Loss Confidential 11 3
  12. 12. B 4.0% 8.0% 12.0% 16.0% 20.0% 24.0% 28.0% 4.0% 8.0% 12.0% 16.0% 20.0% 24.0% 28.0% RAROC Ecap(%) Ecap vis-à-vis Risk Adjusted Returns Limit20% Hurdle 20% Deals in top left quadrant meet the hurdle rate and Ecap % limit Confidential 12 Bubble Size is based on the Sample Deal EAD 3
  13. 13. Binding Constraint…RegC Confidential 13 4 Limit growth Investigate causes Expected Situation Grow if target EC- based RAROC & Min. RC based RAROC is met RC EC RC EC RC EC RC EC Grow as long as EC-based RAROC is met Grow as long as EC-based RAROC is met
  14. 14. Allocation of Equity over EC Confidential 14 TCE Additional Equity held for strategic purposes Not to be Allocated Non-quantifiable risks Stress test of EC To be Allocated EC for all quantifiable risks (credit, market, equity, operational, business) 4
  15. 15. Adjusting Hurdle Rate for Decisions Confidential 15 To meet overall Business level hurdle rate of 15% TCE EC Surplus 2.5% return (risk-free rate) on “uncommitted capital” 25% return on EC to ensure 15% on TCE 4
  16. 16. Concluding Remarks Confidential 16 • It is imperative to take into consideration all key stakeholders and their expectations • Clearly we are evolving to a regime where there are multiple constraints on capital….this should not hold back on building a framework to optimize the requirements • We need to embrace the changes and make them work to our advantage…to stay ahead of competition
  17. 17. Thank You Confidential 17
  18. 18. About the Speaker Confidential 18 Mubadala GE Capital Mubadala GE Capital PJSC is a specialized commercial finance company providing structured financing solutions to businesses across geographies. Headquartered in Abu Dhabi and owned by Mubadala Development Company & GE Capital. Tarun Dara Tarun is currently leading credit risk and portfolio analytics at Mubadala GE Capital. Over last 15 years he has worked in area of underwriting, corporate finance, portfolio analytics and financial risk consulting spread across India, Asia Pacific and Middle East region. His current focus is on building a robust portfolio and capital management framework, governance of risk models in use across diverse asset classes and portfolio quality reviews. Tarun holds an MBA in finance and strategy from IIT, Delhi ; MS (Hons) Economics from BITS, Pilani in India and has graduated from a financial management program with GE.