Optimizing Capital Allocation Strategies

Tarun Dara, Mubadala GE Capital

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

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Preface

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Understand stakeholders & their expectations 1

Considerations for Capital Management 2

Elements in Risk-Adjusted Return Framework 3

Capital Allocation Framework and Strategies 4

Stakeholders of Capital

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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

Challenges at the Board Level

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• 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

Multiple measures of Capital

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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 ?

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Capital Framework

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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

Risk-Adjusted Return Framework

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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

• 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

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3

• 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

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3

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

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3

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%

RA

RO

C

Ecap(%)

Ecap vis-à-vis Risk Adjusted Returns

Lim

it 2

0%

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

Binding Constraint…RegC

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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

Allocation of Equity over EC

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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)

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Adjusting Hurdle Rate for Decisions

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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

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Concluding Remarks

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• 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

Thank You

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About the Speaker

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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.