Economic Capital

What is Economic Capital?

Economic Capital meaning is referred to as the specific measure of the overall risk with respect to the capital. EC or Economic Capital is specifically defined as the total amount of capital that an organization (mostly serving in the field of financial services) would need for ensuring that the company remains solvent due to the given risk profile.

EC or Economic Capital is calculated or measured internally by the given organization –in some cases, making use of the proprietary models. The number or figure that comes as a result of this calculation is also referred to as the amount of capital that the given organization should possess for supporting the given risks it is going to undertake.

Knowing More About Economic Capital

Economic Capital (EC) meaning is used for the purpose of calculating and reporting Market as well as operational risks across the given financial firm. Economic capital is known to measure the overall risk with the help of economic realities instead of using regulatory & Accounting rules. This is because such rules could be sometimes misleading. Due to this, economic capital is considered to possess a highly realistic representation of the solvency of the given firm.

The process of measuring the economic capital Factor is known to involve the conversion of the given risk to the capital amount that might be required for supporting the same. The given calculations tend to be based on the overall financial strength of the organization (credit rating also) along with the overall expected losses.

Financial strength of an organization is referred to as the probability of the organization of not becoming insolvent across the given measurement period. Otherwise, it is referred to as the confidence level in the given statistical measurement. The overall expected loss of the company is the estimated average loss across the measurement period. The given set of expected losses of the company is known to represent the overall cost of executing a business. Therefore, these are mostly absorbed by the respective operating profits.

The overall measurement of EC along with its utilization in reward or risk ratios tend to reveal which specific business lines should a Bank go ahead with for making the best use of the given risk or reward trade-off. Performance calculations that are known to utilize the concept of EC (Economic Capital) are:

• RORAC –return on risk-adjusted capital
• RAROC –risk-adjusted return on capital
• EVA –Economic Value added

Organizations that are known to perform better on the given measures are known to receive more of the capital of the organization for optimizing the overall risks. VaR (Value at Risk), along with similar measures, are also known to be based on the concept of economic capital while being utilized by financial organizations for ensuring effective risk management.