Evaluating Design Choices in Economic Capital Modeling: A Loss Function Approach

US Treasury Office of the Comptroller of the Currency Economics Working Paper No. 2004-2

14 Pages Posted: 4 Oct 2004

See all articles by Nicholas M. Kiefer

Nicholas M. Kiefer

Cornell University - Department of Economics

C. Erik Larson

Promontory Financial Group

Date Written: September 2004

Abstract

This paper considers issues relating to the segmentation or grouping of credit exposures and the potential impact upon economic capital allocation and attribution. When discussing capital allocation, we refer to the assessment of total capital at the portfolio level, while our discussion of capital attribution focuses on getting capital assigned appropriately at the bucket level.

We emphasize that a loss or value function must be specified so as to quantify the gains and losses from choosing a more or less granular asset segmentation scheme. Our chosen loss function considers the trade-off between the decrease in sampling variance obtained by combining data to increase sample size and the bias resulting from characterizing unlike assets with the same default probability.

The implications are illustrated with several numerical examples that consider accuracy in the estimation of both portfolio-level and asset-level capital requirements. The suggested technique can be used to quantify whether a loss in accuracy from grouping or segmentation is outweighed by the decrease in variance of estimated capital. That is, the loss from grouping is small when the evaluation criterion is the accuracy of estimation of the required total capital; grouping is of more concern when we are interested in getting capital attributed correctly at the bucket level.

Keywords: Economic Capital, Basel, Rating System, Granularity, Loss Function

JEL Classification: C15, E58, G21, G28

Suggested Citation

Kiefer, Nicholas M. and Larson, C. Erik, Evaluating Design Choices in Economic Capital Modeling: A Loss Function Approach (September 2004). US Treasury Office of the Comptroller of the Currency Economics Working Paper No. 2004-2, Available at SSRN: https://ssrn.com/abstract=598903 or http://dx.doi.org/10.2139/ssrn.598903

Nicholas M. Kiefer

Cornell University - Department of Economics ( email )

490 Uris Hall
Ithaca, NY 14853-7601
United States

C. Erik Larson (Contact Author)

Promontory Financial Group ( email )

1201 Pennsylvania Avenue, NW
Suite 617
Washington, DC 20004
United States
202-384-1200 (Phone)

HOME PAGE: http://www.ceriklarson.com

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