Extreme Events – Specimen Answer A.8.3 –
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Q. You are a financial
services entity operating in a regulated environment in which your capital
requirements are defined by a nested stress test approach as described in
Section 8.3.3. Your investment manager has approached you with a new service
which will involve the manager explicitly optimising your investment strategy
to minimise your regulatory capital requirements and is proposing that you pay
them a performance related fee if they can reduce your capital requirements.
Set out the main advantages and disadvantages (to you) of such a strategy.
The strategy should result in reduced regulatory capital and hence
higher risk-adjusted return on capital, RAROC (if the firm’s overall capital
base is adjusted accordingly). If the firm is particularly capital constrained
then any mitigation of capital requirements may be attractive to it.
The answers are likely to be very sensitive to the precise structure of
the capital requirements, and hence may change significantly if these
requirements change (as generally seems to happen through time). More
specifically, it is quite likely that the optimisation process will
disproportionately favour elements of the existing capital framework that are
most out-of-line with what might turn out to be applicable over the longer
term. Thus the adage that unless carefully done optimisation can merely involve
error maximisation rather than return maximisation is potentially particularly
An investment strategy that minimises regulatory capital requirements at
the expense of everything else is likely to give insufficient weight to return
in any risk/return trade-off.
Arguably, the problem can be converted into a mathematical exercise the
optimal answer for which is known in advance, but with you having insufficient
analytical tools to uncover it yourself. Arguably, this is not the sort of
exercise for which performance related fees are ideal, since the main justification
for such fee arrangements are that they provide better alignment of incentives
between the manager and the client.
Financial services entities are usually nowadays (at least in the UK)
expected to determine what they think is an intrinsically appropriate amount of
capital to hold irrespective of any particular regulatory capital computations
specified by the regulator. The proposed service may result in the company
unduly focusing on the regulatory capital requirement (given the proposed fee
structure) which means that it runs the risk of giving insufficient emphasis to
risks to which it might be exposed but which do not figure prominently in its
regulatory capital computation.
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