Economic Capital (EC)

What Is Economic Capital?

Economic capital is a measure of risk in terms of capital. All the more specifically, it's the amount of capital that a company (ordinarily in financial services) requirements to guarantee that it stays dissolvable given its risk profile.

Economic capital is calculated inside by the company, now and again utilizing proprietary models. The subsequent number is likewise the amount of capital that the firm ought to need to support any risks that it takes.

Economic capital is not quite the same as regulatory capital, otherwise called capital requirement.

Grasping Economic Capital

Economic capital is utilized for measuring and reporting market and operational risks across a financial organization. Economic capital measures risk utilizing economic real factors instead of accounting and regulatory rules, which can at times be deceiving. Therefore, economic capital is remembered to give a more reasonable representation of a firm's solvency.

The measurement interaction for economic capital implies switching a given risk over completely to the amount of capital that supporting it is required. The calculations depend on the establishment's financial strength (or credit rating) and expected losses.

Financial strength is the likelihood of the firm not becoming wiped out over the measurement period and is also called the confidence level in the statistical calculation. The firm's expected loss is the anticipated average loss over the measurement period. Expected losses address the cost of carrying on with work and are typically absorbed by operating profits.

The relationship between the frequency of loss, amount of loss, expected loss, financial strength or confidence level, and economic capital should be visible in the accompanying graph:

Calculations of economic capital and their utilization in risk/reward ratios uncover which business lines a bank ought to seek after that utilize the risk/reward compromise. Performance measures that utilization 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 a greater amount of the firm's capital to enhance risk. Value-at-risk (VaR) and comparable measures are likewise founded on economic capital and are involved by financial institutions for risk management.

Illustration of Economic Capital

A bank needs to evaluate the risk profile of its loan portfolio throughout the next year. Specifically, the bank needs to decide the amount of economic capital expected to retain a loss moving toward the 0.04% mark in the loss distribution comparing 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. On the off chance that the bank had a shortfall in economic capital, it could go to lengths, for example, raising capital or expanding the underwriting standards for its loan portfolio to keep up with its ideal credit rating. The bank could additionally break down its loan portfolio to evaluate if the risk-reward profile of its mortgage portfolio surpassed its personal loan portfolio.

Features

• Economic capital is the amount of capital that a company needs to endure any risks that it takes. It's basically an approach to measuring risk.
• Financial services companies work out economic capital inside.
• Economic capital ought not be mistaken for regulatory capital (otherwise called a capital requirement).