BROWSE

Economic Capital

What is 'Economic Capital'

Economic capital is the amount of capital that a firm, usually in financial services, needs to ensure that the company stays solvent given its risk profile. Economic capital is calculated internally, sometimes using proprietary models, and is the amount of capital that the firm should have to support any risks that it takes.

Explaining 'Economic Capital'

The measurement process for economic capital involves converting a given risk to the amount of capital that is required to support it. The calculations are based on the institution's financial strength (e.g., credit rating) and expected losses. Financial strength is represented by the probability of the firm not becoming insolvent over the measurement period and is the confidence level in the statistical calculation. Most banks use a confidence measurement of between 99.96% and 99.98%, which is the insolvency rate expected for an institution with a AA or Aa credit rating. The firm's expected loss is the anticipated average loss over the measurement period. Expected losses represent the cost of doing business and are usually absorbed by operating profits.

Performance Measures Using Economic Capital

Economic capital is used for measuring and reporting market and operational risks across a financial organization. Economic capital measures risk using economic realities rather than accounting and regulatory rules, which have been known to be misleading. As a result, economic capital is thought to give a more realistic representation of a firm's solvency.

Example of Economic Capital

A bank wants to evaluate the risk profile of its loan portfolio over the next year. Specifically, the bank wants to discern the amount of economic capital needed to absorb a loss approaching the 0.04% mark in the loss distribution corresponding to a 99.96% confidence interval. The bank finds that a 99.96% confidence interval yields $1 billion in economic capital in excess of the expected (average) loss. If the bank had a shortfall in economic capital, it could take measures such as raising capital or increasing the underwriting standards for its loan portfolio in order to maintain its desired credit rating. The bank could further break down its loan portfolio in order to evaluate if the risk-reward profile of its mortgage portfolio exceeded its personal loan portfolio.


Further Reading


An optimization approach to the dynamic allocation of economic capital
www.sciencedirect.com [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …

Trends in park tourism: Economics, finance and managementTrends in park tourism: Economics, finance and management
www.tandfonline.com [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …

Is green and profitable sustainable? Assessing the trade-off between economic and environmental aspectsIs green and profitable sustainable? Assessing the trade-off between economic and environmental aspects
www.sciencedirect.com [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …

An empirical comparison of published replication research in accounting, economics, finance, management, and marketingAn empirical comparison of published replication research in accounting, economics, finance, management, and marketing
www.sciencedirect.com [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …

Financial deepening and economic development of Nigeria: An empirical investigationFinancial deepening and economic development of Nigeria: An empirical investigation
papers.ssrn.com [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …

Capital account liberalization, financial depth, and economic growthCapital account liberalization, financial depth, and economic growth
www.sciencedirect.com [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …

Using experimental economics to measure social capital and predict financial decisionsUsing experimental economics to measure social capital and predict financial decisions
www.aeaweb.org [PDF]
… Insurance: Mathematics and Economics. Volume 35, Issue 2, 11 October 2004, Pages 299-319. Insurance: Mathematics and Economics … In particular, we formalize a procedure to determine (i) the optimal amount of economic capital to be held by a financial conglomerate, (ii …



Q&A About Economic Capital


Why do banks use economic capital?

Banks use it to evaluate their loan portfolios over time and determine how much risk they can take on in order to maintain their desired credit rating. They also use it to break down their portfolios into smaller parts in order to evaluate if certain types of loans have higher or lower risks than others. This allows them to make better decisions about what kinds of loans they want to offer customers based on the bank's own preferences and standards for acceptable risk levels.

What is economic capital?

Economic capital is the amount of capital that a firm needs to ensure that it stays solvent given its risk profile.

What does economic capital measure?

Economic capital measures market and operational risks across an organization.

What is the total physical capital at any given moment in time referred to as?

The total physical capital at any given moment in time is referred to as the capital stock (not to be confused with the share capital of a business entity).

How would you find out how much excess capacity you have in your portfolio using statistical analysis ?

You could look at your loss distribution curves for different confidence intervals (or other probability distributions) and see where you fall short compared with your expected losses (the average).

How does capital differ from land and other non-renewable resources?

Capital can be increased by human labor, and does not include certain durable goods like homes and personal automobiles that are not used in the production of saleable goods and services.

How does economic capital differ from accounting rules?

Accounting rules are misleading, while economic reality is not. As a result, economic capital gives a more realistic representation of solvency.