Research On The Economic Capital Allcoation Of Investment Bank In China

From the late70s of the last century, the economic capital, as the new ideas and new means in risk management, has been widely used in risk management practices by foreign financial institutions. The large domestic commercial banks like China Construction Bank, Agricultural Bank of China have started to bring in economic capital as an important content of the internal risk management, there are many differences in operating characteristics and risk performance between investment bank which is service-oriented and derivatives-based and conversion business based commercial banks. So whether economic capital management originated in commercial bank risk management practices is equally applicable to the investment bank? Although the International Organization of Securities Commissions (IOSCO) and the EU reflect the thinking of economic capital, yet there is no risk investment bank economic capital allocation system research aiming at investment bank’s special asset and liability structure, daily mark to market accounting institutional arrangements as well as off-balance sheet highly leveraged operating characteristics. This requires systemic and scientific evaluation combined with specific risk characteristics of the investment bank.The paper is divided into four parts including seven chapters.Part1is Chapter1, introduction, whose focus is the research questions’ logical starting point and related literature review.Part2demonstrated the applicability of economic capital allocation in the investment banking from the inside (Chapter2) and outside (Chapter3) of investment bank.(1) on the analysis idea of business structure-operating characteristics-risk performance-economic capital allocation applicability, from the modern investment bank normal risk analysis and Chinese investment bank special risk analysis, combined with the synergetics theory, Chapter2demonstrates the applicability of collaborative risk management of investment bank based on economic capital allocation, from an internal perspective.(2) Chapter3studies the applicability from the perspective of net capital regulation, from the analysis of the failure of the net capital regulation in the subprime crisis in the United States, to the empirical analysis of investment banks’ risk behavior under China’s net capital supervision. This chapter puts forward the validity of net capital regulation and its evaluation criteria, and finally with the experience of two capital management defense, regulatory capital and economic capital of commercial banks, in the Basel Agreement, it demonstrated economic capital allocation could build investment bank risk prevention barrier together with the net capital regulation.Part3studies the theory of investment bank economic capital allocation and its examples in China, including Chapter4, Chapter5and Chapter6. Chapter4establishes the theoretical framework of the investment bank economic capital allocation, and based on this framework chapters5and6make theoretical and empirical research respectively from the two areas of asset allocation and capital structure optimization. Specifically:(1) Establish theoretical framework of investment bank economic. Chapter4builds economic capital allocation system based on dual constraints of net capital regulatory and economic capita, analyzes investment bank’s capital configuration principle of net capital and economic capital in different constraints and brings forward the application areas of investment bank economic capital allocation (asset allocation, capital structure optimization and performance evaluation) and the corresponding selection of economic capital measurements.(2) Theory and empirical evidence of investment bank asset allocation and capital structure optimization based on economic capital allocation:〤hapter5builds investment bank asset allocation model under the dual constraints, and based on GARCH-CVaR model and GARCH-VaR model, it makes an empirical study and comparison of China’s listed investment bank’s proprietary asset configuration data; Chapter6using options model, based on the corrected top-down total economic capital measure, establishes three investment bank capital structure optimization model based on economic capital allocation under dynamic state (with or without the consideration of dividend distribution) and static cases, theoretically demonstrates factors that influence overall necessary economic capital (desirable capital structure or net capital), and brings up investment bank’s capital structure optimization strategy under dual constraints, and a case study.Part4is Chapter7, analyzing the external and internal environment construction of Chinese investment banks to carry out economic capital allocation, and comes up with the path of gradual promoting economic capital allocation.The main conclusions of this paper:(1)Owing to the unique asset-liability structure, mark-to-market accounting system and the highly leveraged business characteristics both inside and outside the sheet, modern investment banks bear higher pro-cyclical risks, contain more aggressive culture of risk and are more inclined to occur negative externalities brought by liquidity risk and bankruptcy, compared with commercial banks. And, microeconomic evidences of the aforesaid conclusion could be found in the US five biggest investment banks. In the meantime, as the fundamental effect of the market enhanced in the allocation of the resources and the risk management of problem investment banks in China transformed to marketization, under the mixed businesses competition pressure, reform in interest rate and the further expansion in RMB exchange rate fluctuation, the risk characteristics of Chinese investment banks are gradually similar to the ones in the US. Finally, according to synergetics theories, it holds that the collaborated risk management theory based on the economic capital allocation could constrain the aggressive risk culture in investment banks and such theory can be the standard of leverage degree (from the angle of management and regulation).(2) With the use of3SLS method, the paper empirically analyzes Chinese listed investment banks’capital adjustment and risk taking behaviors restrained by net capital regulation since2008new regulation. The research finds that the listed investment banks operate in accordance with the "risk-capital" matching principle and the net capital regulation is becoming the tight restraint against the operating businesses of investment banks; the design of the indicators in net asset regulation is not reasonable, and although the overall indicators play a positive role in risk management of investment banks, yet the structure indicator is quite opposite to the policy expectations that investment banks with insufficient capital may also increase capital in form of bearing more risks to obtaining higher profit. (3)Although economic capital and net capital are regarded as two different capital restraints of investment bank operations, these two have inherent convergence owing to links with risk. So consistent collaboration and error-correcting mutual study is needed by both the investment bank and the regulation department to make economic capital allocation and net capital allocation regulation play a positive role in investment bank asset allocation, capital structure optimization and performance assessment. Therefore, effective investment bank risk management shield could be constructed by the joint effort.(4) Based on the capital allocation model of investment bank double restraints of the net capital and economic capital, the paper empirically finds that the net capital requirement of the Chinese listed investment banks’self-operated asset is higher than the economic capital requirement; the accounting profit is higher than the economic profit; the allocation method based on GARCH-CVaR model is more effective than the one based on GARCH-VaR model. And these conclusions are conformed to the theoretical analytical conclusion that the economic capital allocation can prevent the investment bank from moral hazard.(5) With the investment bank’s capital structure optimization model based on the economic capital allocation, the paper empirically finds that the total net capital requirement of investment bank in the case is too high and the leverage multiplier too low. This conclusion is also in conformity with the theoretical analytical conclusion that the economic capital allocation can be used for the loose net capital regulation of the investment bank.The main innovation or contribution of the paper:(l)The paper systematically and comprehensively demonstrates the applicability of the investment bank’s economic capital allocation from both the internal risk management and external net capital regulation angles, and attempts to unify these two parts through the synergetics theory into one analytical framework:collaborative risk management of the investment bank based on economic capital allocation. The research finds that economic capital allocation is capable of preventing the relatively higher moral hazard and financial leverage risk of modern investment banks and provides policy reference to the accepted degree of the asset capital regulation, In addition, it can also make up the insufficiency of the investment bank’s asset capital regulation guidelines by the IOSCO and EU which only imply the economic capital thoughts and of related documents lack of systematic demonstration.(2)The paper establishes the economic capital allocation system of the investment bank based on the double restraints of asset capital regulation and economic capital. Furthermore, it analyzes the investment bank’s capital allocation principle of the asset capital and economic capital in different restraint nature and puts forward the application fields of investment bank’s economic capital allocation (asset allocation, capital structural optimization and performance assessment) and the corresponding selection of economic capital measurements.(3)The paper establishes the investment bank’s asset allocation model under double restraints and conduct empirical research by use of the self-operated asset allocation data of the Chinese listed investment bank in which finds that the asset capital requirement of the self-operated asset is higher than the economic capital requirement; accounting profit is higher than the economic profit; the allocation method based on GARCH-CVaR model is more effective than the one based on GARCH-VaR model. And these conclusions can prove the theoretical analysis that the economic capital allocation can prevent the investment bank from moral hazard.(4) using options model, based on the corrected top-down total economic capital measure, this paper establishes three investment bank capital structure optimization model based on economic capital allocation under dynamic state (with or without the consideration of dividend distribution) and static cases, theoretically demonstrates factors that influence overall necessary economic capital (desirable capital structure or net capital), and brings up investment bank’s capital structure optimization strategy, and conducts a case study which shows that the total net capital requirement of investment bank is too high and the leverage multiplier is too low. This laterally proves that the economic capital allocation can be used for the establishment of a reasonable financial leverage degree of investment bank and its loose net capital regulation.The deficiencies and further research direction:In this paper, deficiencies which also show the further directions of research are as follows:(1)Economic capital allocation is an overall risk management tool. The empirical part of the paper, Chapter five, just studies the self-operated businesses’ market risk because of the limited data. Obviously, the risk of investment bank not only comes from market but also from self-operated departments. So, there may be differences between empirical findings and practical situations of investment bank.(2)Chapter six of the paper sets up dynamic models and static models for the capital structure optimization of investment bank based on economic capital allocations, but there is no empirical study for dynamic model. What’s more, the existing demonstration is given merely in form of case study; the samples are not enough and the conclusion is not that convincing.(3)Although the mixed trend affects investment banks and its risk management as mentioned, the research object in this paper is limited to independent investment bank rather than risk management problems of financial group under the mixed operation. For this reason, the research’s application fields are limited.