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.
BREAKING DOWN '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.
The relationship between frequency of loss, amount of loss, expected loss, financial strength and economic capital can be seen in the following graph:
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.
Calculations of economic capital and their use in risk/reward ratios reveal which business lines a bank should pursue that maximize the risk-reward trade-off. Performance measures that utilize economic capital include return on risk adjusted capital (RORAC), risk adjusted return on capital (RAROC) and economic value added (EVA). Business units that perform better on measures like these can receive more of the firm's capital in order to optimize risk. Value-at-risk (VaR) and similar measures are also based on economic capital and are used by financial institutions for risk management.
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.