Economic capital
Basel II regulations
Economic capital
Allocation of economic capital
55 Rabobank Group Annual Report 2005
Organisation and risk management: risk management
The new Basel accord on capital adequacy ('Basel II') represents an inte
grated framework for the supervision of banks and is founded on three
pillars. In pillar 1, minimum capital adequacy requirements are set for all
banks for credit risk, market risk and operational risk. Within each risk
category, banks can choose from a number of approaches, which vary
from simple to advanced. Moreover, regulatory bodies can set additional
capital requirements and quality standards for other risk categories.
Under the rules in pillar 2, the supervisory authority ensures that the
bank has identified, quantified and managed all other relevant risks. For
Rabobank Group, these are interest rate risk, country risk and business
risk. Pillar 3 addresses market discipline, requiring banks to publish risk
information with a view to stimulating market forces.
The Basel II accord was used in 2005 by the European Commission as
a basis for preparing the Capital Requirement Directive (CRD). All EU
member states must have implemented this Directive in national legis
lation by 1 January 2007. This will lead to a more sophisticated system
of risk weightings and hence to more risk-sensitive capital requirements
than under the current Basel I requirements. At the end of 2006,
Rabobank will start a two track approach, under which capital
adequacy requirements are calculated according to both the old and
the new regulations.
On certain conditions, banks are allowed to use their internal models to
determine the amount of capital to be held. Rabobank Group has deve
loped sophisticated internal models for both credit risk and operational
risk, which comply with the guidelines of the supervisory authority.
The Directives for these sophisticated models will take effect in the EU
member states from 1 January 2008. Under the Basel II regulations,
Rabobank Group's relatively low risk profile is reflected in much lower
capital requirements and hence a significantly improved solvency ratio.
This expectation is confirmed by the outcome of Rabobank's preliminary
calculations, made in the context of the Quantitative Impact Study 5.
The results of this study, which was performed in many countries, will
be used by supervisory authorities to assess whether the Basel II accord
does in fact generate the outcomes preferred by them.
Besides the supervisor's minimum capital requirements, Rabobank
applies an internal capital requirement: economic capital. Economic
capital is defined as the amount of capital to be held by the bank to
absorb any unexpected losses without becoming insolvent, based on a
one-year period and a confidence level set by Rabobank. Since Rabobank
Group wishes to retain its current highest rating (Triple A), it has elected
to apply a confidence level of 99.99%. Rabobank Group uses the most
advanced statistical methods to determine the amount of economic
capital required to be held.
Rabobank Group sets these high standards for itself because of the
importance it attaches to retaining the highest possible credit rating.
This rating means that rating agencies consider the probability of default
to be practically nil. Risk diversification also plays an important role in
the calculation of economic capital. Better diversification means less
economic capital is required, as there is a lower probability of unexpected
losses occurring simultaneously within different risk categories.
Rabobank Group's total economic capital for 2005 has been calculated
at EUR 14.9 (13.0) billion. This increase was due partly to the growth in
Rabobank Group's activities and partly to model improvements introdu
ced in 2005. The level of economic capital is comfortably below that of
the available Tier I capital (core capital) of EUR 24.9 billion. This large
capital buffer again confirms Rabobank Group's solid position.
The concept of economic capital enables the bank to quantify, analyse
and subsequently manage the various risks that the bank is exposed to.
In relative terms, credit risk remains the largest risk category. A quarter
of the economic capital is necessary for operational risks and business
risks. Interest rate risk and market risk together account for another
quarter of the economic capital. Insurance risk and country risk are
relatively small risks for Rabobank Group. At the end of 2005, Interpolis
merged with Achmea and in its place came a substantial minority inte
rest in Eureko. The calculations of economic capital are still based on a
100% risk profile for Interpolis. In 2006, the way the risk profile of the
minority interest in Eureko is to be integrated in the economic capital
model will be reviewed. The greatest shift in 2005 was in both credit
and market risk. The share of credit risk increased as a result of the rela
tive growth of the loan portfolio. The ratio was also altered by model
and data improvements. Market risk was reduced by the sale of
Effectenbank Stroeve and Gilde Investment Management. In 2005,
economic capital for operational risk was calculated based on the most
advanced model for the first time.
Viewed by business unit, the domestic retail banking accounts for nearly
half of the economic capital required at Group level. The sale of
Effectenbank Stroeve and Gilde Investment Management caused the
share of the participating interests to decline. The increase in wholesale
banking and international retailbanking can be attributed to strong
autonomous growth.
