In
financeFinance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money and risk and how they are interrelated...
, mainly for financial services firms,
economic capital is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a
going concernA going concern is a business that functions without the intention or threat of liquidation for the foreseeable future, usually regarded as at least within 12 months.-Use in Accounting:...
, such as
market riskMarket risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:* Equity risk, the risk that stock prices will change....
,
credit riskCredit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit .-Faced by lenders to consumers:...
, and
operational riskAn operational risk is a risk arising from execution of a company's business functions. As such, it is a very broad concept including e.g. fraud risks, legal risks, physical or environmental risks, etc. The term operational risk is most commonly found in risk management programs of financial...
. It is the amount of money which is needed to secure survival in a worst case scenario. Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital.
Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic
balance sheetIn financial accounting, a balance sheet or statement of financial position is a summary of a person's or organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a...
stays solvent over a certain time period with a pre-specified probability.
In
financeFinance is the science of funds management. The general areas of finance are business finance, personal finance, and public finance. Finance includes saving money and often includes lending money. The field of finance deals with the concepts of time, money and risk and how they are interrelated...
, mainly for financial services firms,
economic capital is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a
going concernA going concern is a business that functions without the intention or threat of liquidation for the foreseeable future, usually regarded as at least within 12 months.-Use in Accounting:...
, such as
market riskMarket risk is the risk that the value of an investment will decrease due to moves in market factors. The four standard market risk factors are:* Equity risk, the risk that stock prices will change....
,
credit riskCredit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit .-Faced by lenders to consumers:...
, and
operational riskAn operational risk is a risk arising from execution of a company's business functions. As such, it is a very broad concept including e.g. fraud risks, legal risks, physical or environmental risks, etc. The term operational risk is most commonly found in risk management programs of financial...
. It is the amount of money which is needed to secure survival in a worst case scenario. Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital.
Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic
balance sheetIn financial accounting, a balance sheet or statement of financial position is a summary of a person's or organization's balances. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a snapshot of a...
stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as
value at riskIn financial mathematics and financial risk management, Value at Risk is a widely used measure of the risk of loss on a specific portfolio of financial assets...
.
The first accounts of economic capital date back to the ancient Phoenicians, who took rudimentary tallies of frequency and severity of illnesses among rural farmers to gain an intuition of expected losses in productivity. These calculations were advanced by correlations to predictions of climate change, political outbreak, and birth rate change.
The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the organization.
See also
- Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
- Financial services conglomerate
- Financial risk management
Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...
- RAROC, risk-adjusted return on capital
External links