This checklist defines economic capital and explains how it is calculated.
Economic capital is the amount of risk capital that a company must have to cover any risks it is facing, such as operational risk, credit risk, or market risk. The amount held is that needed to ensure the business could overcome a worst-case scenario and still survive. Economic capital must be realistically estimated to manage the risks and to budget the costs of regulatory capital that needs to be maintained across the different divisions of the company. It is not the same as regulatory capital, which is a mandatory sum that a company must hold. The sum is determined by the regulators. Financial services should aspire to ensure the amount of risk capital they hold is at least equal to their economic capital.
Economic capital is calculated by determining the amount of capital that a company must have at its disposal to ensure it remains solvent over a defined period of time, taking into account the probability of any risks actually occurring. Thus, economic capital is usually calculated as the value-at-risk (VaR), where VaR is defined as the tipping point for the probability of a mark-to-market loss on the business within the predetermined timeframe, assuming the markets are stable and no trading has occurred. There is no universally accepted method for calculating economic capital.
The full economic scenario (FES) method is an approach that takes into account all possible risks for a company, and is useful where the main goal is to determine the economic capital for all the combined risks. However, the FES approach does not allocate any explicit amount of economic capital to any particular risk. It is calculated by applying a set of economic scenarios to all divisions of the company, then applying assumptions for each scenario. These assumptions usually include interest, equity returns, inflation, defaults, and actual versus expected claims for various products.
A one year mark-to-market, stress-testing approach to calculating economic capital is probably the easiest and fastest way to quantify a company’s risk exposure and achieve quantifiable business benefits.
Combining results that have been derived over different time horizons, even where they have been calculated consistently, can present difficulties as it allows risks in one timeframe period to be hedged against other risks in a different timeframe, which may be unjustifiable.
First calculate the potential losses for each risk category. The more detailed the calculation, the better, but you may find that you do not have sufficient data to do more than a simple assessment.
Next determine the probability and severity of such losses. Use a VaR model for market price risks and self-assessment for operational and strategic risk to generate the possible losses and their distribution across the business. Allow for worst-case scenarios when determining how severe losses could theoretically be.
Consider using scenario analysis to determine the risk probabilities of infrequent but severe events, as these are hard to calculate within economic capital.
Dos and Don’ts
Remember that the use of economic capital as an internal model for capital adequacy has been driven by regulatory requirements, particularly the Solvency II proposals, which introduce a comprehensive risk management framework for defining required capital levels, and implementing procedures to identify, measure, and manage risk levels.
Don’t forget that strategic risks are not usually calculated when determining economic capital, as it makes no sense to calculate a capital charge for this unless a suitable modeling method is used that considers the benefits of the strategic options.