Capital Allocation considerations given the recent changes in the regulatory landscape in financial services

1. Optimizing Capital Allocation
Strategies
Tarun Dara, Mubadala GE Capital
Confidential

2. Efficient use of scarce resources Land, Labour
and “Capital”…..
- Adam Smith (Wealth of Nations in 1776)
Confidential 2

3. Preface
Confidential 3
Understand stakeholders & their expectations1
Considerations for Capital Management2
Elements in Risk-Adjusted Return Framework3
Capital Allocation Framework and Strategies4

4. Stakeholders of Capital
Confidential 4
SHAREHOLDERS
consideration is to maximize
value creation in form of
dividend and growth
optimize capital
BONDHOLDERS
consideration is likelihood of
repayment of principal and
interest
risk of default
REGULATORS
consideration is capital
adequacy, stressed outcomes
gradually trending
towards risk-sensitive
capital measures
RATING AGENCIES
consideration is on capital
strength, economic capital
risk & capital
management framework
1

5. Challenges at the Board Level
Confidential 5
• How much capital is required to support the various
risks in my business ? How does this compare to
regulatory and rating agency capital constraints ?
• What returns should we be/are we getting on that
capital ?
• Are the various business segments/individual
investments meeting the threshold returns ? What
does this tell us about how we should allocate capital
and resources ?
1

6. Multiple measures of Capital
Confidential 6
Economic Capital (EC)
Accounts for diversification and concentration risk, facilitates strategic
planning, limit setting, as well as defining risk appetite
Regulatory Capital (RegC)
Binding constraint, change in portfolio composition can require drastic
action…sale of business unit, access capital markets at unfavorable terms
Regulatory Stress Test Capital (RSTC)
Advent of recent regulations, FI’s face constraints that are increasingly
impacting investment decisions
Is there a need for unified measure…EC, RegC & RSTC ?
Should all influence decision making ?
2

7. Capital Framework
Confidential 7
Risk Vs. Capital
Capital Protection
Risk Vs. Reward
Capital Development
• Aligning Book Capital,
Regulatory & Economic
Capital
• Using Economic Capital to
set limits
• Stress Testing and
Scenario Analysis
• Rating Strategy
• Integrating Economic
Capital in Strategic
Planning Processes
• Risk-adjusted Pricing
• Risk-adjusted performance
management
• Optimization and active
credit portfolio
management
Business
Benefits
(Economic
Security)
Business
Benefits
(Safeguard
Profitability)
DEBT HOLDER’S
PERSPECTIVE
SHAREHOLDER’S
PERSPECTIVE
2

8. Risk-Adjusted Return Framework
Confidential 8
Income - Operating Expenses – Expected Loss + Capital Benefit
Economic Capital
EVA =
A Risk-Adjusted Performance Measurement (RAPM) links
risk (the amount of economic capital consumed) with
returns (the risk –adjusted returns adjusted).
RAROC =
Risk Adjusted Return – (Economic Capital x Hurdle Rate)
3

9. • Probability of
Default Within 1
year
• Default =
Bankruptcy,
90 Days Past
Due,
Restructuring to
Avoid Default
• Economic
Losses Post
Default
• Includes All
Costs, Timing of
Recoveries
• Function Of
Collateral,
Seniority
• Expected Size of
Exposure at
Default
• Need to model
for Revolvers &
for other
unfunded
commitments
• “Cost Of Doing
Business”
• Given
Predictable, not
“Risk” per se
• Typically
reflected in
Pricing
Probability
of Default
Loss
Given
Default
Exposure
At Default
Expected
Losses
=
X X
Expected Loss
Confidential 9
3

10. • Economic Capital (Ecap) is the amount of capital a
business or product require, for a given amount of risk,
to achieve a specified level of confidence that an
extreme loss will not exceed the capital
• Measured as the potential loss in excess of EL over one
year time period at a specified confidence level or
criterion
• Represents comprehensive risk measurement which can
be thought of as “unit of risk”
Economic Capital
Confidential 10
3

11. Economic Capital is Provided to Cover Extreme or “Tail Risk” Events
EL
Probability of a “Tail Risk” Event is a function of
Unexpected Loss (Volatility)
Expected Loss Vs. Unexpected Loss
Confidential
11
3

12. B
4.0%
8.0%
12.0%
16.0%
20.0%
24.0%
28.0%
4.0% 8.0% 12.0% 16.0% 20.0% 24.0% 28.0%
RAROC
Ecap(%)
Ecap vis-à-vis Risk Adjusted Returns
Limit20%
Hurdle 20%
Deals in top left quadrant meet the hurdle rate and Ecap % limit
Confidential
12
Bubble Size is based on the Sample Deal EAD
3

13. Binding Constraint…RegC
Confidential 13
4
Limit growth
Investigate causes
Expected Situation
Grow if target EC-
based RAROC &
Min. RC based
RAROC is met
RC EC RC EC
RC EC RC EC
Grow as long as
EC-based RAROC
is met
Grow as long as
EC-based RAROC
is met

14. Allocation of Equity over EC
Confidential 14
TCE
Additional Equity held
for strategic purposes Not to be Allocated
Non-quantifiable risks
Stress test of EC
To be Allocated
EC for all quantifiable risks
(credit, market, equity,
operational, business)
4

15. Adjusting Hurdle Rate for Decisions
Confidential 15
To meet overall
Business level
hurdle rate of
15%
TCE
EC
Surplus
2.5% return (risk-free
rate) on “uncommitted
capital”
25% return on EC to
ensure 15% on TCE
4

16. Concluding Remarks
Confidential 16
• It is imperative to take into consideration all key
stakeholders and their expectations
• Clearly we are evolving to a regime where there are
multiple constraints on capital….this should not hold back
on building a framework to optimize the requirements
• We need to embrace the changes and make them work to
our advantage…to stay ahead of competition

17. Thank You
Confidential 17

18. About the Speaker
Confidential 18
Mubadala GE Capital
Mubadala GE Capital PJSC is a specialized commercial finance company providing
structured financing solutions to businesses across geographies. Headquartered
in Abu Dhabi and owned by Mubadala Development Company & GE Capital.
Tarun Dara
Tarun is currently leading credit risk and portfolio analytics at Mubadala GE
Capital. Over last 15 years he has worked in area of underwriting, corporate
finance, portfolio analytics and financial risk consulting spread across India, Asia
Pacific and Middle East region. His current focus is on building a robust portfolio
and capital management framework, governance of risk models in use across
diverse asset classes and portfolio quality reviews. Tarun holds an MBA in finance
and strategy from IIT, Delhi ; MS (Hons) Economics from BITS, Pilani in India and
has graduated from a financial management program with GE.