Extreme Events – Specimen Answer A.8.3 – Answer/Hints

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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.


Advantages include:


-          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.


Disadvantages include:


-          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 appropriate here.


-          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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