Introduction

The calculation of economic capital brings together many of the principles discussed throughout this book, covering risk measures and aggregation in particular detail. The issue of economic capital is also important to a number of departments within a financial organisation. One way to see the extent to which this is true is to consider why economic capital might be calculated. However, it is important first to understand exactly what economic capital is.

Definition of Economic Capital

There are a number of ways that economic capital can be defined, but most definitions contain three similar themes:

1. • they refer to additional assets or cash flows to cover unexpected events;

2. • they refer to an amount needed to cover these unexpected events to a specified measure of risk tolerance, with risk being measured in some way; and

3. • they consider the risk over a specified time horizon.

A common definition of economic capital is the additional value of funds needed to cover potential outgoings, falls in asset values and rises in liabilities at some given risk tolerance over a specified time horizon. It can also be defined as the funds needed to maintain a particular level of solvency (ratio of assets to liabilities) or the excess of assets over liabilities, again at some given risk tolerance over a specified time horizon.

Risk tolerance can also have a number of meanings, referring to a percentile of the results, a value of loss or the result of some other key indicator.

Economic Capital Models

Economic capital is calculated using an economic capital model. This is used to create simulations of the future financial state of an institution so that the range of potential outcomes can be analysed. These outcomes are then used in the calculation of some measure of risk that allows for an assessment of the level of capital that should be held, given a pre-specified risk tolerance and time horizon.

Economic capital models can be internal or generic. Each type is discussed below.

Internal Capital Model

An internal capital model allows a firm to determine how much capital it should hold to protect it against adverse events. It not only gives a better understanding of the financial implications of the current strategy, but also allows the implications of any potential change in strategy to be assessed.