Economic Capital

AAA

DEFINITION of 'Economic Capital'

The amount of capital that a firm, usually in financial services, needs to ensure that the company stays solvent. Economic capital is calculated internally and is the amount of capital the firm should have to support any risks it takes on.

The measurement process 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 will 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:

Economic Capital

INVESTOPEDIA EXPLAINS '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, it is thought to give a more realistic representation of a firm's solvency.

RELATED TERMS
  1. Solvency Ratio

    One of many ratios used to measure a company's ability to meet ...
  2. Capital

    1) Financial assets or the financial value of assets, such as ...
  3. Capital Outflow

    The movement of assets out of a country. Capital outflow is considered ...
  4. Solvency

    The ability of a company to meet its long-term financial obligations. ...
  5. Liquidity Risk

    The risk stemming from the lack of marketability of an investment ...
  6. Risk

    The chance that an investment's actual return will be different ...
Related Articles
  1. Fundamental Analysis

    Analyzing A Bank's Financial Statements

    A careful review of a bank's financial statements can help you identify key factors in a potential investment.
  2. Personal Finance

    Using Economic Capital To Determine Risk

    Discover how banks and financial institutions use economic capital to enhance risk management.
  3. Markets

    Intangible Assets Provide Real Value To Stocks

    Intangible assets don't appear on balance sheets, but they're crucial to judging a company's value.
  4. Options & Futures

    Advanced Financial Statement Analysis

    Learn what it means to do your homework on a company's performance and reporting practices before investing.
  5. Stock Analysis

    What Are Intel’s Hopes In The Processor Market?

    Intel has pretty minimal share in the smartphone applications processor market, despite some heavy investments in products for the segment.
  6. Stock Analysis

    What's DISH’s Strategic Direction In The Industry?

    Telecommunications industry has evolved from being a backwater of ultra-conservative utility-like stocks to a high-growth area for cutting-edge investors.
  7. Stock Analysis

    What Are Kinder Morgan’s Plans For Growth In 2016?

    One thing investors likely love about Kinder Morgan is its robust backlog of future projects, like growing its generous dividend by 10% per year.
  8. Economics

    Iron Ore Market: Falling Into The Hands Of A Few

    The big iron ore mining companies have embarked on a drive to increase supply, reduce cost, and take market share.
  9. Stock Analysis

    Why Should You Invest In Stratasys Today?

    When Stratasys pre-announced its fourth-quarter earnings, management highlighted that its MakerBot acquisition was underperforming expectations.
  10. Investing

    What's a Debit Note?

    A debit note is a document used by a seller to inform a purchaser of a dollar amount owed. As the name indicates, it is a note from the seller that a debit has been made to the purchaser’s account. ...

You May Also Like

Hot Definitions
  1. Fixed-Charge Coverage Ratio

    A ratio that indicates a firm's ability to satisfy fixed financing expenses, such as interest and leases. It is calculated ...
  2. Efficiency Ratio

    Ratios that are typically used to analyze how well a company uses its assets and liabilities internally. Efficiency Ratios ...
  3. Fixed Cost

    A cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses ...
  4. Subsidy

    A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy ...
  5. Sunk Cost

    A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business ...
  6. Technical Skills

    1. The knowledge and abilities needed to accomplish mathematical, engineering, scientific or computer-related duties, as ...
Trading Center