In
finance, mainly for financial services firms, economic capital (ecap) 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 concern, such as
market risk
Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility.
There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the mos ...
,
credit risk
A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
,
legal risk, and
operational risk. It is the amount of money that 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 sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as
value at risk
Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...
. The balance sheet, in this case, would be prepared showing market value (rather than book value) of assets and liabilities.
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 climate change, political outbreaks, and birth rate change.
The concept of economic capital differs from
regulatory capital
A capital requirement (also known as regulatory capital, capital adequacy or capital base) is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital ad ...
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.
__NOTOC__
In social science
In
social science, ''economic capital'' is distinguished in relation to other types of capital which may not necessarily reflect a
monetary
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are a ...
or
exchange-value
In political economy and especially Marxian economics, exchange value (German: ''Tauschwert'') refers to one of the four major attributes of a commodity, i.e., an item or service produced for, and sold on the market, the other three attributes b ...
. These forms of capital include
natural capital,
cultural capital
In the field of sociology, cultural capital comprises the social assets of a person (education, intellect, style of speech, style of dress, etc.) that promote social mobility in a stratified society. Cultural capital functions as a social relati ...
and
social capital; the latter two represent a type of power or status that an individual can attain in a
capitalist
Capitalism is an economic system based on the private ownership of the means of production and their operation for profit. Central characteristics of capitalism include capital accumulation, competitive markets, price system, private p ...
society via formal education or through social ties. Non-economic forms of capital have been variously discussed most famously by sociologist
Pierre Bourdieu.
See also
*
Asset allocation
Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment ti ...
*
Basel I
*
Basel II
*
Capital structure
In corporate finance, capital structure refers to the mix of various forms of external funds, known as capital, used to finance a business. It consists of shareholders' equity, debt (borrowed funds), and preferred stock, and is detailed in the ...
*
Financial risk management
*
Financial services conglomerate
*
RAROC, risk-adjusted return on capital
*
RORAC, return on risk-adjusted capital
*
Solvency II
References
*
*
*
External links
FDIC.gov Economic Capital and the Assessment of Capital Adequacy
Federal Deposit Insurance Corporation
BIS.org "Basel Committee, Bank for International Settlements"
Economic Capital - A PreambleCEIOPS"
{{Sociology-stub
Actuarial science
Financial risk