Managing Economic and Virtual Economic Capital Within Financial Conglomerates |
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| Authors: | Marc J Goovaerts PhD Eddy Van den Borre Roger J A Laeven PhD |
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| Institution: | 1. Catholic University of Leuven, Dept , Applied Economics, Naamsestraat 69 , B-3000 Leuven , Belgium;2. Dept. of Quantitative Economics , University of Amsterdam , Roetersstraat 11, 1018 WB Amsterdam , The Netherlands;3. Fortis Bank Insurance, Wolvengracht 48 , 1000 Brussels , Belgium;4. Dept. of Applied Economics , Catholic University of Leuven , Naamsestraat 69, B-3000 Leuven , Belgium;5. University of Amsterdam, Dept , Quantitative Economics, Roetersstraat 11 , 1018, WB Amsterdam , The Netherlands;6. Mercer Oliver Wyman , Startbaan 6, 1185 XR Amstelveen , The Netherlands |
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| Abstract: | Abstract In this paper we show how the optimal amount of economic capital can be derived such that it minimizes the economic cost of risk-bearing. The economic cost of risk-bearing takes into account the cost of the economic capital as well as the exposure to residual risk. In addition to the absolute problem of determining the amount of economic capital, we also consider the relative problem of how to establish the allocation of economic capital among subsidiaries. Because subsidiaries are juridical entities, they will also consider the absolute problem of economic capital allocation themselves. In an equilibrium situation, the relative allocation derived by the conglomerate and the absolute allocation derived by the subsidiaries coincide. We show that the diversification benefit that is typically obtained in a conglomerate construction creates a virtual economic capital for subsidiaries within the conglomerate. We show further that the approach we propose to solve the absolute problem of economic capital allocation also can be applied to the problem of optimal portfolio selection, extending the well-known Markowitz approach and providing a tool for management by economic capital. |
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