Active capital management: Optimising returns in a multiple stakeholder context

Current approaches to economic capital management focus on the risk capital needed to maintain solvency and on portfolio management (eg hedging and diversification). These approaches ‘passively’ allocate capital to subportfolios subject to hurdle rates (eg risk-adjusted return on capital), implying that debt-holders provide a binding constraint on the institution's risk appetite based on the target credit rating and its assumed quantile. The emergence of ‘active’ value creation — that is, pursuing optimal asset returns while managing capital structure in relation to stakeholder risk appetite — moves from an implicit debt-holder orientation to one that combines the perspectives of all stakeholders within a multi-tiered capital structure. The analysis illustrates the potential application of scenario-based constrained optimisation techniques to jointly evaluate the risk-return preferences of multiple stakeholders. Assessing investment (asset allocation) and funding (capital structure) decisions simultaneously suggests that optimal portfolio choices change significantly when stakeholders' different risk perspectives are considered together. While optimisation techniques are used to formalise the decision-making process, the results apply to any decision rule — whether optimisation-based, analytical or heuristic. The implication is that management decisions that consider debt and equity-holder perspectives jointly are better aligned with equity-holders' preferences (while respecting debt-holder constraints) than decisions based solely on debt-holders' risk preferences.