Chapter 4 - Operational Risk and Tiering Capital

[Shillington]

Hi,

I have two questions:

1.) One of the reasons why companies elect to go with internal models instead of relying of the Standard Formula (SF) is to get a reduction in their capital requirements. One large difference between the SF and an internal model approach is that operational risk is treated as having no diversification benefits in the SF, but in internal models it can be heavily diversified. Why is this allowed? It seems very disparate.

2.) From my perspective, on a balance sheet you have Assets, Liabilities and then Equity. Equity being the remaining funds left over for Shareholders in the event that the company were immediately sold or wound up, and also what I consider the "available capital" to be for a company. What does "ordinary shares" mean as an example of Tier 1 capital?

For example, on the Aviva balance sheet at YE14 they had the following items:

Equity
Ordinary share capital 737
Preference share capital 200
Called up capital 937
And other items

I don't understand how they can hold 'Ordinary Share Capital $737m' on their balance sheet. This is money which has been paid by shareholders to the company in exchange for shares. But the company has then spent that money backing projects and employing people and it has surely moved to different items on the balance sheet (e.g. operating expenses, reinsurance payable etc etc). How can you hold a reserve for something like that?

Thanks

 

[Katherine Young]

operational risk is treated as having no diversification benefits in the SF, but in internal models it can be heavily diversified. Why is this allowed?

You can do what you like with an internal model, so long as you can satisfy the regulator that it's reasonable. The intricacies of the standard formula were developed over a period of years, after input from across the financial services industry (not just GI remember). Much of it was heavily debated even then. Don't waste time trying to justify every little detail.

I don't understand how they can hold 'Ordinary Share Capital $737m' on their balance sheet. This is money which has been paid by shareholders to the company in exchange for shares. But the company has then spent that money backing projects and employing people and it has surely moved to different items on the balance sheet (e.g. operating expenses, reinsurance payable etc etc). How can you hold a reserve for something like that?

Your reasoning is rather peculiar here. Shareholders' equity is the balancing item, ie "assets - liabilities". So once you know your total shareholders' equity, the question reduces to just calculating the split between ordinary share capital / preference share capital / other. I suspect the numbers you mention refer to the par value of the stock.

it has surely moved to different items on the balance sheet (e.g. operating expenses, reinsurance payable etc

Again, rather odd. For a start, "operating expenses" would appear on your P&L (ie expenses over the last 12 months), but not on your balance sheet (the snapshot at one instant of time).

Shareholders' equity is generated when the company makes a profit. If a shareholder has given money to the company in exchange for shares, and that company uses that money to generate profit (ie it generates assets in excess of liabilities), then this profit belongs to the shareholder. Think of the shareholders' equity as the accumulated value of all past retained profits.

 

[Shillington]

You can do what you like with an internal model, so long as you can satisfy the regulator that it's reasonable. The intricacies of the standard formula were developed over a period of years, after input from across the financial services industry (not just GI remember). Much of it was heavily debated even then. Don't waste time trying to justify every little detail.

Hi Katherine,
Thanks for your response. I'm not trying to understand "every detail", I just thought that it was odd that in one model you have no diversification and in another you're allowed as much as you want (effectively).

Your reasoning is rather peculiar here. Shareholders' equity is the balancing item, ie "assets - liabilities". So once you know your total shareholders' equity, the question reduces to just calculating the split between ordinary share capital / preference share capital / other. I suspect the numbers you mention refer to the par value of the stock.

Again, rather odd. For a start, "operating expenses" would appear on your P&L (ie expenses over the last 12 months), but not on your balance sheet (the snapshot at one instant of time).

Shareholders' equity is generated when the company makes a profit. If a shareholder has given money to the company in exchange for shares, and that company uses that money to generate profit (ie it generates assets in excess of liabilities), then this profit belongs to the shareholder. Think of the shareholders' equity as the accumulated value of all past retained profits.

I also think that the item is the "par" value of stock. Why is this an item on the balance sheet? It bears no resemblance to actual monies going in and out of the business...?

I understand that "operational expenses" are a cashflow item, what I was talking about if how you have an equity injection (people buy shares) and then this money passes through the company hitting different items, and not just staying as some "lump" in the equity part. Which is also what you're saying.

I'm still confused as to what the Tierings of Capital are referring to in the notes however. How is "shareholder equity" different from capital? (excluding ancillary own funds).

When you say 'split between "ordinary share capital/preference share capital/other"' what do you mean? Suppose that the company is wound up in its current state and reserving etc is done perfectly (i.e. the estimates were fully accurate). Then the liabilities can be knocked off the assets, you're left with the equity, how is this then split between preference shareholders and ordinary shareholders? Is this what you mean when you say "split"? What sort of instrument would go in the "other" bucket? Other debt like corporate bonds etc would surely go in liabilities, so what else can go in there?

 

[Katherine Young]

I also think that the item is the "par" value of stock. Why is this an item on the balance sheet? It bears no resemblance to actual monies going in and out of the business...?

It's just the accounting norm to do it this way.

I'm still confused as to what the Tierings of Capital are referring to in the notes however. How is "shareholder equity" different from capital? (excluding ancillary own funds).

Mostly, no difference at all. Shareholders' equity is available to meet liabilities if required (so long as this is "paid up" capital, ie so long as the shareholders have actually paid the money). Usually, that makes it Tier 1 capital. Mind you, I've a feeling that some forms of preference share capital might not count as Tier 1 capital, eg "cumulative preference shares", see:

http://www.nortonrosefulbright.com/...to-know-about-solvency-ii-capital-instruments
https://en.wikipedia.org/wiki/Preferred_stock

It's easy to research this stuff, you can find out more details yourself online I'm sure.

Then the liabilities can be knocked off the assets, you're left with the equity, how is this then split between preference shareholders and ordinary shareholders?

As per my previous post, I'd say this is just the par value of the issued stock.

What sort of instrument would go in the "other" bucket?

They're not "instruments" as such. For example, if shares are issued above the par value, than this would be called "share premium", or "additional paid-in capital", but would still count as shareholder equity. Then there's retained earnings too of course.

Frankly, I suspect you're going way beyond what the examiners would find interesting, we're practically in CT2 territory. But you never know, it's easy enough to google more details if you think it might come up.

 

[Shillington]

http://www.nortonrosefulbright.com/...to-know-about-solvency-ii-capital-instruments

Thanks Katherine. This is a v good link.