Studying On Application Of Economic Capital Allocation On Chinese Commercial Banks

With the continual deepening of economic and financial globalization, rapid development of information technology and the great breakthrough of financial theory and practice in the past50years, financial products and financial markets show a vigorous development trend. However, these great changes also make the risk commercial banks and other financial institutions faced more and more fluctuant. Many international active banks, who have already established the comprehensive finance risk management system gradually, make use of the advanced risk management technology and the information system to reduce losses created by all kinds of risks as far as possible. As Chinese reform of financial institutions deepening increasingly and financial industry opening up completely, commercial banks have been realized that sound risk management system play a strategic role in their sustainable development. Advanced risk management has become most important core competence of commercial banks.As a foreign scholar said, introduction of mathematical methods is the most attractive respect of risk analysis. Economic capital (EC) that generated by bank internal assessment and allocated to certain business unit is to buffer risk shock, which is the true reflection of risk level the bank in. When EC is close or more than actual capital, the bank take risk excessively. At this time, banks should supplement physical capital or adjust asset structure to reduce the amount of EC.Commercial banks should hold the border of total risk, which is set by EC, to ensure the safety of the banking business. That is the constraint of capital on risk management. EC management should be based on probability of default, loss given default and so on to reflect expect loss actually. We shouldn’t consider EC as a financial management instrument or decide the total amount and allocation according to profit object. Form Basel Ⅱ and the practice of international active banks, EC has been the effective instrument for commercial banks risk management, which is a sound solution to blind expansion of domestic banks. Taking full advantage of the function of capital constraint to make risk management play an important role in the development of banks is a significant and rational strategy. When dealing with the relation among size, development, speed and quality, capital, especially the EC should become the key connection. In this sense, we can say that risk management is the essence of modern commercial banking functions, of which capital management is the central core.EC management in Chinese commercial banks wasn’t put into practice until recent years, but developed rapidly. After2002, when China Construction Bank began to introduce EC management and establish the initial capital allocation scheme, all other state-owned commercial banks and some joint-stock commercial banks, such as China Merchants Bank, China Everbright Bank, and city commercial banks have also begun to study and explore and implement EC management. Through continuous efforts to explore, EC management practices in Chinese banking industry have acquired certain achievement. However, there is still a considerable gap between our commercial banks and international advanced banks. Objectively speaking, unsystematic and insufficient study on theory of economic capital is one of the main reasons for stunting domestic development of practice. In particular, there are few empirical researches on Chinese commercial banks. So the purpose of this dissertation is to fill the gap and put forward some valuable suggestion on EC management of domestic banks.This thesis begins with a systematic introduction of theories related to the allocation of EC, then establishes EC allocation model targeting to maximize the value of bank under the capital restraint and erects the basic framework of operation later. We pursue empirical study on the application of EC based on the physical data of corporate credit portfolio of a state-owned commercial banks’ second branch. Finally we summarize and comment on the practice of domestic EC allocation, and try to provide some feasible and relevant proposals for further development combined with international experience. This paper will divide into8chapters and proceed as follows.Chapter1:Introduction. This part presents background, problem-posing, literature review, study content, method and technique route, possible innovation and defects.Chapter2:Theory related to the allocation of EC. At first we will review the evolution of commercial bank risk management, compare with the characteristics of every phase, and point out that EC management is the advanced stage of commercial bank risk management. Then we will introduce the connotation of EC and compare EC with book capital and regulatory capital. By dividing the loss in commercial bank, we will analyze the potential connection of EC and unexpected loss. At the end three major economic capital measurement methods will be introduced, that is coefficient method, revenue-changing method and asset-volatile method, which is used more and more.Chapter3:Commercial bank EC allocation model. This part begins with EVA and RAROC, which are the core index of EC management. We establish Mean-VaR model based on Modern Portfolio Theory, then conclude that there is an optimal amount of EC to make RAROC maximal. Subsequently, we build the EC Allocation Model to discuses how to allocate EC to every business unit to realize the maximum of RAROC given total EC. Finally we illustrate some applications of EC allocation to stock and increment capital management.Chapter4:The general framework for the allocation of capital economic. The decision on total amount of EC and allocation to every unit in different level constitute the main content of EC management in commercial banks. After comparing several common allocation patterns, we conclude that correspond between top and bottom may be more applicable. We illustrate fundamental framework from responsibility of relevant organizations and implement steps. And applications of EC allocation in commercial banks will be also introduced briefly.Chapter5:Practice of commercial banks capital management in and abroad. This part will review the history of capital management in Chinese banking industry and analyze the predicament of capital and finance faced by domestic commercial banks. Considering external competition and internal management, we figure that it is necessary to implement EC management. We take the example of American Bank to recommend western commercial banks’experience in EC management and summarize the inspiration to domestic commercial banks.Chapter6:Empirical study on Chinese commercial banks economic capital allocation. Based on the physical data of corporate credit portfolio of a state-owned commercial banks’ second branch in2007, we illustrate the applications in the management of capital budget, line risk quota, credit portfolio, loan-pricing and performance measurement by means of Monte Carlo Simulation and EC Allocation Model. Through analyzing the empirical result, we will make some recommendations on the sample bank. Chapter7:Conclusions and prospects. This chapter summarizes the main conclusions of the research work and looked to the future direction of research.