Essays on Economic Capital and Credit Risk Pooling

The thesis contains three papers that treat different influences on a bank’s economic capital for credit risk. The first of these papers analyzes the influence of profits and losses other than losses from credit defaults on a bank’s economic capital. The other two papers are concerned with changes in a bank’s economic capital if this bank participates in a credit risk transfer transaction called credit risk pooling.

In the first paper, we compare the traditional calculation of economic capital for credit default losses with a more comprehensive one based on the bank's (net) profit from credit business as accounted for in the bank’s P&L statement. We show that economic capital needed to buffer losses as of the P&L statement is strictly less than the unexpected loss in EaD from defaults.

The second paper describes the effect of pro rata credit risk pooling transactions on the granularity and the economic capital of regional bank credit portfolios. The change in granularity is described analytically using general properties of concentration measures. The changes in economic capital following pro rata pooling are analyzed by simulating a credit portfolio model.

The third article presents a theoretical model which motivates the participation of regional banks in credit risk pooling with deadweight costs of having either too little or too much economic capital in the spirit of the tradeoff theory of the capital structure. The deadweight costs are given via a variable we call risk overhang. The banks' optimal participation in the pooling and the prices at which credit risks trade are derived. After pooling, banks are never worse off and in many cases pooling increases their welfare. Further, credit risk pooling leads to a more even distribution of risk overhang across banks. However, a completely even distribution is not always achieved.