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Contingency Analysis 1 www.contingencyanalysis.com

Capital Calculations:Has the CCRO Missed the Point?

Glyn A. Holton (2004). Capital calculations: Has the CCRO missed the point?,Energy Risk, 1 (3), 41-42.

In September, the Committee of Chief Risk Officers (CCRO) released its new white

paperEmerging Practices for Assessing Capital Adequacy. The paper notes that, whilecapital calculations are widely used by banks, most energy merchants have not

implemented similar procedures. The paper goes on to describe analytical techniques

energy merchants might employ for this purpose. More pertinent is the question: why

should energy merchants perform capital calculations? To gain insight into this question,

lets consider how the banking industry came to perform capital calculations.

Up until the 1930s, US banks were largely unregulated. Fallout from the crash of 1929

caused many banks to fail. The losses suffered by depositors prompted Congress to

implement Federal deposit insurance. This solved one problem but introduced another.

Because depositors no longer needed to consider credit quality in choosing a bank,

deposit insurance largely eliminated market discipline for banks. With the FederalGovernmentthat is, taxpayersnow shouldering the cost of bank failures, the lost

market discipline needed to be replaced with some sort of regulatory discipline. The new

regulatory system that emerged for banks included, among other things, minimum capital

requirements.

Regulatory capital requirements are based upon a model for how banks operate.

According to this model, every bank has a large mattress stuffed full of cash. This

hypothetical cash is called capital. Any time a bank suffers an unanticipated loss, money

is taken from the mattress to cover the loss. In this way, capital absorbs losses in the

same way that a cars suspension absorbs bumps in the road.

Every day, the bank takes all the money and dumps it out on the bedroom floor. It lines

up its market, credit and operational risks, and places a little pile of its capital next to

each. If risks hedge or diversify each other, there are rules for reducing the piles. The

entire process is called capital allocation. Hopefully, there will be enough capital to build

all the necessary piles, in which case the banks capital is deemed adequate. Otherwise, it

is inadequate, and regulators will intervene.

We all know there is no mattress full of money. Capital is funny money. It is an

accounting construct defined (for the most part) as the book value of owners equity,

reserves, and subordinated debt. It isnt really available to absorb unanticipated losses.

Much of it was invested long ago in things like office buildings and computer equipment.

None of this has anything to do with energy markets, but here is something that does.

While banks capital is funny money, capital charges for the risks they takethe piles

of money on the bedroom floorare serious business. If a bank needs to raise additional

capital to take on new business, there is a financing cost associated with raising that

incremental capital. As a natural consequence of capital requirements, banks started


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assessing proposed transactions in light of the capital charges those transactions would

entail. If a transaction was not expected to earn sufficient profits to cover incremental

financing costs for applicable capital charges, the transaction would be rejected. Note that

the banks total capital was irrelevant to these decisions. All that mattered was the

incremental capital charges.

A problem with this approach to accepting or rejecting transactions was the fact that

capital charges were regulatory devices that were not necessarily related to the true risks

or costs (including opportunity costs) of transactions. Accordingly, banks started to

implement their own internal systems for calculating economic capital charges. These

were designed to more accurately reflect the true economic costs of entering into

transactions. Banks still had to satisfy the old regulatory capital requirements, but they

used economic capital charges for assessing transactions.

Accordingly, when we speak about bank capital, we may refer to either of two notions:

regulatory capital, whose purpose is assessing the overall viability of a firm, and economic capital, whose purpose is supporting transaction-level decision making.

Certainly both forms of capital have been used for both of the indicated purposes. As we

have mentioned, banks have in the past (and in some cases still do) assess transactions

based upon regulatory capital considerations. Also, they sometimes employ economic

capital to calculate bank wide metrics of financial viabilitymetrics such as economic

capital adequacy or risk-adjusted return on economic capital. However, the primary

purpose of regulatory capital is assessing banks financial viability. The primary purpose

of economic capital is supporting transaction-level decision making.

For energy merchants, there is no regulatory capital. The only type of capital energymerchants might calculate is some sort of economic capitaland the CCRO is proposing

various formulas they might use to calculate economic capital.

Now lets return to the question that motivated this article: why should energy merchants

perform capital calculations? Looking to the banking industry, we see two possible

reasons:

the regulatory purpose of assessing a firms financial viability, and

the risk management purpose of supporting transaction-level decision making.

We might expect the CCRO to follow banks lead and emphasize the latter purpose, but itdoesnt! Its white paper emphasizes the use of economic capital to assess the financial

viability of an energy merchant. In this regard, the CCRO is not borrowing a risk

management concept (economic capital) from banking and implementing it as a risk

management concept for energy merchants. Instead, it is borrowing a regulatory concept

(regulatory capital) from banking and implementing it as a risk management concept for

energy merchants.


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The executive summary for the CCROs white paper identifies four reasons for energy

merchants to perform capital calculations:

management can use the framework to assess the long-run viability of a companys

business model ;

management can use the framework for decision making regarding capital allocationby bringing to the forefront risks implicit in a proposed project or business plan ;

if a company is facing a capital shortfall, a capital adequacy framework will help

management evaluate the effects of specific corrective actions ; and

the capital adequacy framework may help promote transparency throughout the

industry

Three of these envision capital calculations being used to assess the viability of energy

merchants. Only one envisions them being used to support transaction-level decision

making. This emphasis is reflected in the white paper itself. It explains in detail how

capital calculations might be performed to assess the viability of a firm. It offers little

guidance on how they might be applied to support transaction-level decision making.

Is the CCRO missing the point of economic capital? They appear to be.

In its white paper, the CCRO asserts

Capital is a key barometer of financial health, providing investors assurances that

the company is viable and can weather uncertain outcomes.

Capital is not a single notion. It represents a different notion every time someone

proposes a new formula for calculating it. In its white paper, the CCRO introduces two

possible formulas for calculating capital. Without any sort of empirical justification, theCCRO claims that these offer a key barometer of financial health. Various notions of

capital have long been used as an indicator of financial health for depository institutions,

but their application to energy merchants is less developed. I am sure the formulas

proposed by the CCRO have some predictive ability, but does this rise to the level of a

key barometer?

The financial literature documents a number of established models for assessing a firms

financial health. Among these are Altmans Z-score, asset value models and reduced

form models. There is also traditional credit analysis that employs various financial

ratiosonly one of which might be some metric of capital adequacy. If the CCRO wants

to endorse some model as a barometer of an energy merchants financial health,exploring these established alternatives might be preferable to reinventing the wheel with

their own capital formulas.

In this article, I have described capital as funny money. I suspect that energy executives

have been slow to implement capital allocation because they look at the notion of capital

and draw a similar conclusion. If this is the case, the solution may not be for the CCRO to

propose better methods to calculate a proxy for hypothetical money in a hypothetical


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mattress. Rather, it may be for the CCRO to shift its focus and promote capital

calculations primarily for supporting transaction-level decision making.

It is not clear to me whether or not energy merchants should be implementing expensive

capital allocation systemsnot all banks do! An argument might be made that each

energy merchant should answer the question for itself based on the nature of its ownbusiness. It would be beneficial if the CCRO laid out such an argument and offered

energy merchants guidance in making this important decision. To do so effectively, the

CCRO needs to make an honest assessment of (1) what capital calculations are useful for

and (2) what they are not useful for. To give capital allocation credibility in the eyes of

industry executives, the CCRO should articulate the latter as clearly as it does the former.

Glyn A. Holton is a risk consultant and author of the new bookValue-at-Risk: Theory

and Practice.

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