What is an Economic Capital?
Economic capital is the measure of the risk exposure of a firm’s capital. It is the amount of money required by a business to ensure that it maintains solvency given its risk profile. Economic capital is a financial term that refers to the amount of money a company needs to keep on hand to protect against potential losses. This measure is particularly important for companies in industries with high risks, such as banking, insurance, and financial services companies.
Economic capital is a key metric for investors and creditors, as it provides insight into a company’s financial health and its ability to meet its obligations. A company with a strong economic capital position is better able to weather economic storms and take advantage of opportunities when they arise. Economic capital is also an important consideration for regulators, as it can impact a company’s ability to comply with rules and regulations.
Economic capital refers to the amount of money that a company or individual has available to invest in new ventures or to cover unexpected losses. Economic capital is a risk-measurement term used by financial companies to define the amount of money required to keep operations afloat, considering the risks associated with company assets.
It is a key component of a company’s financial stability and ability to weather economic downturns. Economic capital is typically calculated as the sum of cash, investments, and other assets minus liabilities.
Explanation of Economic Capital
Financial services firms, such as banks and insurance companies, make use of financial capital. You may also use it to evaluate and assess a financial services firm’s market and operational risks. The economic capital framework takes into account both inherent risk and regulatory rules. Because of this, it is seen as a more accurate reflection of a financial service firm’s solvency.
To measure economic capital, one must estimate the risk of a company and how much money would be necessary to cover those losses in a negative situation. These estimations usually come from the financial institution’s past history and projected future losses. A company’s financial strength is represented by its credit rating, which measures the probability of that company defaulting. The main credit rating agencies are-
- S&P Global
- Fitch Ratings
A company’s financial strength is often gauged by its ability to avoid defaulting on loans or other payments. This metric takes into account different confidence levels when making statistical calculations.
To assist in making judgments, economic capital variables are incorporated into the risk and reward profiles. An analysis of economic capital, for example, might advise a bank to take certain business lines due to their high profitability. If an institution’s economic capital is strong, the management team may conclude that it has sufficient financial stability to make more risky loans and undertake more volatile commercial activities such as equities sales and trading.
Alternately, if a bank’s economic capital is discovered to be weak, the management team may decide that loans should be made more safely and less volatile business operations such as retail banking or wealth management should be pursued. Economic capital can be measured in several ways, including Value-at-Risk (VaR), Return on risk-adjusted capital (RORAC), Economic value added (EVA), Return on risk-adjusted capital (RORAC), etc.
Methods for Calculating Economic Capital
To ascertain economic capital, various methods can be used. The most popular way is through a risk-based model that considers the different risks a corporation might face. Also, Monte Carlo simulations and stress testing are other methods. They create a gamut of potential outcomes from which we can then determine how much economic capital is needed.
Value-at-risk (VaR) models are typical EC frameworks for the market, credit risk, and other risks. However, credit risk is usually referred to as credit value-at-risk (CVaR). Consider the distribution of losses for a loan portfolio with relatively safe loans. The expected loss is the sum of all possible losses from day-to-day operations, but the unexpected loss will be the amount by which the anticipated loss differs from the average (the tail of the distribution). Economic capital can be defined as the number of assets required to cover an unexpected loss.
There are different types of VaR models, but they all share some common features: a time horizon, a confidence level, and an underlying distribution of returns. The most popular VaR model is the historical simulation VaR model. In this method, we take actual historical data and compute the distribution of returns. Then, we determine how often a certain loss level is exceeded.
Some banks may use custom-built models to compute their ECs. However, banks may also benefit from commercial software when performing EC calculations. Moody’s KMV, Strategic Analytics, Credit Suisse’s Credit Risk+, and JPMorgan’s CreditMetrics are all examples of such software for credit risk assessment.
Economic capital can also be expressed in terms of return on risk-adjusted capital (RORAC). RORAC is a performance metric that adjusts the net income of a company by the amount of risk taken to generate that income. The higher the RORAC, the more efficient a company is at using its capital to generate profits. Economic value added (EVA) is another performance metric that measures the amount of value a company creates for its shareholders.
Using Economic Capital to Determine Risk Tolerance
Economic capital can be used to help management teams make informed decisions about how much risk they are willing to take on. A company with a strong economic capital position may be willing to take on more risk than a company with a weak economic capital position.
Economic capital can also be used to set limits on exposure to certain types of risk. For example, a company may decide that it is willing to take on up to $10 million of credit risk. This means that the company will not lend more than $10 million to any one borrower. Economic capital can also be used to set limits on other types of risk, such as market risk or operational risk.
Economic capital can also be used to help a company diversify its risk. For example, a company with a strong economic capital position may choose to invest in a new product line that is risky. By diversifying its risk, the company can protect itself from the potential losses that could occur if the new product line fails.
Let us understand how risk management, regulatory capital, and economic capital are interrelated
Risk management is the process of identifying, measuring, and managing risk. Regulatory capital is the amount of capital that a financial institution is required to hold by regulatory bodies. Economic capital is the amount of capital that a financial institution needs to cover its unexpected losses.
1. Risk Management
Basel Accords are a set of recommendations for the banking industry that aim to improve risk management functions at important financial institutions. The three sets of regulations included in the accords are Basel I, II, and III.
Basel I focuses on credit risk, Basel II focuses on both credit and operational risk, and Basel III focuses on all types of risk and provides international directives regarding that.
2. Regulatory Capital
To comply with the Basel Accords, financial institutions are required to hold a certain amount of regulatory capital. This is the amount of money that a bank must have available to cover its losses.
Economic capital is the amount of money that a bank needs to cover its unexpected losses. Economic capital requirements are typically higher than regulatory capital requirements because they take into account all types of risk, not just credit and operational risk.
Economic capital requirements may also be higher than regulatory capital requirements because they account for the fact that some losses may not be recoverable. For example, if a bank lends money to a company and the company goes bankrupt, the bank may not be able to recover all of the money it is owed.
Importance of Economic Capital
Five reasons behind the importance of economic capital are
1. Performance measure: Economic capital is a performance metric that adjusts the net income of a company by the amount of risk taken to generate that income. The higher the RORAC, the more efficient a company is at using its capital to generate profits.
2. Comparing to regulatory capital: Economic capital requirements are typically higher than regulatory capital requirements because they take into account all types of risk, not just credit and operational risk. Economic capital requirements may also be higher than regulatory capital requirements because they account for the fact that some losses may not be recoverable.
3. Diversification: Economic capital can also be used to help a company diversify its risk. For example, a company with a strong economic capital position may choose to invest in a new product line that is risky. By diversifying its risk, the company can protect itself from the potential losses that could occur if the new product line fails.
4. Limits on other risks: Economic capital can also be used to set limits on other types of risk, such as market risk or operational risk.
5. To measure a company’s financial health: Economic capital is a good metric to use to measure a company’s financial health because it takes into account all types of risk. A company with a strong economic capital position is likely to be in good financial health.
Challenges in Economic Capital Modeling
Economic capital modeling is a complex process that requires a deep understanding of the risks faced by a company. Many challenges can make economic capital modeling difficult, including:
1. Identifying all of the risks faced by a company: A company may face many different types of risk, such as credit risk, market risk, and operational risk. It can be difficult to identify all of the risks faced by a company and quantify those risks.
2. Estimating the probability of events: Economic capital models require estimates of the probability of events, such as the probability of a loan default or the probability of a natural disaster. These probabilities can be difficult to estimate accurately.
3. Estimating the loss given an event: Economic capital models also require estimates of the loss that would occur if an event did occur. For example, if a loan defaults, how much money would the bank lose? These losses can be difficult to estimate accurately.
4. Choosing the right model: There are many different types of economic capital models, and it can be difficult to choose the right model for a company.
5. Ensuring the model is accurate: Economic capital models are complex, and it can be difficult to ensure that they are accurate. If a model is not accurate, it could lead to a company taking on too much or too little risk.
On the concluding note, it is clear that economic capital measures the risk of an organization and is used to determine how much capital an organization must have to continue operating. Economic capital is important for both national and international settlements. It is also a key performance measure.
Economic capital refers to the risk capital of a company, which is the amount of money that a company sets aside to cover unexpected losses. Economic capital is important for both national and international settlements.
What do you think is the most important use of economic capital? Let us know in the comments below!