Risk-based capital, or Capital At Risk(CAR), is the amount of capital which is actually based on objective risk measures. It protects the unexpected loss that represents over the average loss. The deviation of losses from the mean at the given tolerance level is the unexpected loss. It is distinct from regulatory capital or available capital.
The purposes of this study are to show how to measure risk capital and to use it in financial institution. As practical uses of measured risk capital, I focused on the capital allocation, risk-adjusted performance measurement and customer price decision.
There are two ways of measuring risk capital ; Earnings-volatility-based approach and asset-volatility-based approach. In this study I applied earnings-volatility-based approach to the revenues data of "A" bank in Korea by business unit between Jan. 1997 and Sep. 1999. I showed how to use the measured risk capital in allocating capital, measuring RAROC (Risk-adjusted return on capital), SVA(Shareholders Value Added) and using these data in deciding the customer price of loan.
Of course this study has some limitations. The normality of loss distribution is prerequisite in earnings-volatility-based approach and it does not offer the clue of future real risk management. It also requires the exact cost allocation to businesses but cost management system is not working yet in Korean banking.
To solve these problems, risk capital should be measured by the firm-wide risk management system and the study on the method of aggregating risks over portfolios is necessary. Accounting should be done not only by account but also by business units, products and transactions to make cost allocation explicit. After all, the comprehensive profit management linked with the risk management system should be provided. In that case, the risk management system will function as a profit-creating system.
