Economic Capital

Economic capital accounts for capital that a financial institution needs to hold to cover the risks it is facing. Essentially, economic capital is the amount of money needed to secure survival in a severely adverse scenario. This means that, if the available capital of a financial institution exceeds its economic capital, the financial institution is able to weather heavy shocks. Although economic capital is a real economic principle, it is instrumental for the management of capital and even for regulators, which rely heavily on economic capital models. If there were no supervision of financial institutions at all, risk and capital managers would still use the metrics of economic capital. Moreover, this chapter is also useful to recollect why economic capital is such an important metric for financial institutions. It also describes why financial institutions need to consider economic capital in their everyday business. The principle of economic capital is to attach a probability to each possible loss (or gain). As it is impossible to attach a probability to one specific outcome, one typically tries to quantify for each number the probability that a loss in any given year will be smaller than that number.