Economic capital is a risk measure that is defined in terms of capital. It is essentially the amount of capital that a financial company requires to stay solvent given the riskiness of its assets and operations.
Economic capital is usually generated internally by financial companies using estimations and forecasting models. The result is the amount of capital that the company should keep on hand to support risks and stresses.
Understanding Economic Capital
Economic capital is used by financial services companies, such as banks and insurance firms. It is also used for measuring and gauging the market and operational risks of a financial services company.
Economic capital captures the inherent risk of the economic environment, as opposed to regulatory and accounting rules. Because of such a fact, it is thought of as giving a more accurate representation of the solvency of a financial service company.
Measuring economic capital involves rating the risk in a company and the amount of capital needed to support that risk in an adverse scenario. The calculations are usually based on the financial institution’s financial strength and expected losses.
Financial strength includes the probability of default for a firm. It can usually be represented in the form of a credit rating, which is an assessment of the creditworthiness of individuals or entities.
All public companies are given a credit rating that is generally issued by the three main credit rating agencies:
The financial strength considers the probability of a company not defaulting over a certain period. This probability is taken into the confidence level in statistics calculations.
The expected loss is the average loss over a certain period. Expected losses are the costs of doing business and other unexpected losses. For example, a bank may have expected losses from borrowers defaulting on their loans. An insurance company may have expected losses arising from claims on various policies.
Economic capital factors in the risk and reward profiles to help inform decisions. For example, an analysis of economic capital may inform the decisions of a bank to pursue certain business lines.
If economic capital reveals that a bank has strong economic capital, then the management team can decide that the bank could afford to make riskier loans and pursue more volatile business operations such as capital markets operations (investment banking, sales and trading, etc.).
On the other hand, if a bank discovers that its economic capital is weak, the management team may decide that the bank should make safer loans and pursue less volatile business operations such as retail banking or wealth management business lines.
Some performance measures that factor in economic capital include:
Management evaluates business lines that can optimize the measures and focus capital allocation toward those businesses.
Uniqueness of Financial Services Companies
Economic capital is important for financial services companies because of the unique business models that these companies employ.
Most companies will sell a product and service in exchange for money and profits. However, financial companies will use the money itself and manipulate the timing and allocation of cash flows to generate profits.
For example, banks adopt unique business models in which their core operations are not to manufacture or sell a good or service. Instead, they take money from individuals or other entities in the form of deposits.
The money is kept safe and earns an interest rate to compensate the depositors for depositing their money. Then, the bank will lend out the money to entities and will charge a higher interest rate and profit off of the spread between the rate paid to depositors and the rate charged to borrowers.
Such a business model faces unique risks, as well. The risk that many depositors may wish to withdraw their money all at once is significant. It is mitigated by ensuring that the bank holds on to a certain amount of capital to ensure its solvency and be able to repay depositors.
Banks face regular risks from routine defaults that can occur, which result in a low impact on the overall operations. However, the bank must also be prepared for catastrophic losses and events, such as recessions and market crashes. Such events are considered when internally forecasting economic capital.
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