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Managing Economic and Virtual Economic Capital Within Financial Conglomerates

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  • Marc Goovaerts
  • Eddy Van den Borre
  • Roger Laeven

Abstract

In this paper we show how the optimal amount of economic capital can be derived such that it minimizes the economic cost of risk-bearing. The economic cost of risk-bearing takes into account the cost of the economic capital as well as the exposure to residual risk. In addition to the absolute problem of determining the amount of economic capital, we also consider the relative problem of how to establish the allocation of economic capital among subsidiaries. Because subsidiaries are juridical entities, they will also consider the absolute problem of economic capital allocation themselves. In an equilibrium situation, the relative allocation derived by the conglomerate and the absolute allocation derived by the subsidiaries coincide. We show that the diversification benefit that is typically obtained in a conglomerate construction creates a virtual economic capital for subsidiaries within the conglomerate. We show further that the approach we propose to solve the absolute problem of economic capital allocation also can be applied to the problem of optimal portfolio selection, extending the well-known Markowitz approach and providing a tool for management by economic capital.

Suggested Citation

  • Marc Goovaerts & Eddy Van den Borre & Roger Laeven, 2005. "Managing Economic and Virtual Economic Capital Within Financial Conglomerates," North American Actuarial Journal, Taylor & Francis Journals, vol. 9(3), pages 77-89.
    • Handle: RePEc:taf:uaajxx:v:9:y:2005:i:3:p:77-89
    DOI: 10.1080/10920277.2005.10596212
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    Citations

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    Cited by:

    1. van Gulick, Gerwald & De Waegenaere, Anja & Norde, Henk, 2012. "Excess based allocation of risk capital," Insurance: Mathematics and Economics, Elsevier, vol. 50(1), pages 26-42.
    2. Mierzejewski, Fernando, 2006. "Liquidity preference as rational behaviour under uncertainty," MPRA Paper 2771, University Library of Munich, Germany.
    3. Mierzejewski, Fernando, 2007. "The Money Demand with Random Output and Limited Access to Debt," MPRA Paper 6688, University Library of Munich, Germany.
    4. Righi, Marcelo Brutti & Müller, Fernanda Maria & Moresco, Marlon Ruoso, 2020. "On a robust risk measurement approach for capital determination errors minimization," Insurance: Mathematics and Economics, Elsevier, vol. 95(C), pages 199-211.
    5. Mierzejewski, Fernando, 2007. "An actuarial approach to short-run monetary equilibrium," MPRA Paper 2424, University Library of Munich, Germany.
    6. Mierzejewski, Fernando, 2008. "The cost of capital in markets with opaque intermediaries and the risk-structure of interest rates," MPRA Paper 9827, University Library of Munich, Germany.
    7. Mierzejewski, Fernando, 2008. "The optimal liquidity principle with restricted borrowing," MPRA Paper 12549, University Library of Munich, Germany.
    8. Carry Mout, 2006. "An Upper Bound of the Sum of Risks: two Applications of Comonotonicity," DNB Working Papers 105, Netherlands Central Bank, Research Department.
    9. Kim, Joseph H.T. & Hardy, Mary R., 2009. "A capital allocation based on a solvency exchange option," Insurance: Mathematics and Economics, Elsevier, vol. 44(3), pages 357-366, June.
    10. van Gulick, G. & De Waegenaere, A.M.B. & Norde, H.W., 2010. "Excess Based Allocation of Risk Capital," Other publications TiSEM f9231521-fea7-4524-8fea-8, Tilburg University, School of Economics and Management.
    11. Fernando MIERZEJEWSKI & Katholieke Universiteit, 2009. "Towards A General Theory Of Liquidity Preference," Journal of Applied Economic Sciences, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. 4(2(8)_ Sum).
    12. Mélina Mailhot & Mhamed Mesfioui, 2016. "Multivariate TVaR-Based Risk Decomposition for Vector-Valued Portfolios," Risks, MDPI, vol. 4(4), pages 1-16, September.
    13. Fernando MIERZEJEWSKI, 2008. "The Economic Capital Of Opaque Financial Institutions," Journal of Applied Economic Sciences, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. 3(3(5)_Fall), pages 232-245.
    14. Mierzejewski, Fernando, 2008. "The Allocation of Economic Capital in Opaque Financial Conglomerates," MPRA Paper 9432, University Library of Munich, Germany.
    15. Mierzejewski, Fernando, 2007. "The Short-Run Monetary Equilibrium with Liquidity Constraints," MPRA Paper 6526, University Library of Munich, Germany.
    16. Goovaerts, Marc J. & Kaas, Rob & Laeven, Roger J.A., 2010. "Decision principles derived from risk measures," Insurance: Mathematics and Economics, Elsevier, vol. 47(3), pages 294-302, December.
    17. Kim, Joseph H.T. & Kim, So-Yeun, 2019. "Tail risk measures and risk allocation for the class of multivariate normal mean–variance mixture distributions," Insurance: Mathematics and Economics, Elsevier, vol. 86(C), pages 145-157.

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