Economic Capital

Economic Capital (EC) refers to the amount of financial resources a company needs to absorb potential losses due to the risks and uncertainties within its operations. It has multiple purposes, like measuring the risk-taking capacity, aiding in risk management decisions, plus ascertaining the correct amount of capital to fight adverse events.

EC plays a key role in measuring the overall sturdiness of an organization using factors like operational risk, liquidity risk, market risk, and credit risk. Thus, it helps in allocating capital amongst different business units, compliance with regulatory requirements, and evaluating the success of new investments. A firm with adequate EC protects it from financial problems plus potential risks, promotes stakeholders' confidence, and anchors its long-term sustainability.

• Economic Capital (EC) refers to the number of financial resources needed to absorb potential losses due to risks and uncertainties within a firm, serving multiple purposes such as measuring risk-taking capacity, aiding in risk management decisions, and determining the appropriate capital required to withstand adverse events.
• Its formula involves subtracting the expected liabilities and the capital buffer from the total assets.
• It represents the net financial resources, including securities, equity, and debt, needed to withstand losses from uncertainties and risks within a firm. In contrast, regulatory capital represents the minimum mandated capital amount set by regulatory authorities to ensure financial stability and solvency.
• Economic capital represents the financial resources required to withstand losses from uncertainties and risks within a firm. In contrast, cultural capital encompasses non-financial assets.

Economic capital can be defined as a metric utilized to quantify the amount of capital a company needs to withstand financial stress, litigation, or risks associated with future uncertainties. Thus, it helps in determining a company's risk-taking ability and financial resilience. It came to the fore in the nineties when financial institutions began increasing risk management practices.

Furthermore, financial institutions such as banks and insurance companies depend on economic capital generated internally through estimations and forecasting models. This capital represents the amount necessary to support risks and uncertainties, providing a more accurate measure of a company's solvency than regulatory and accounting rules.

As per the definition of economic capital, its assessment involves evaluating the company's risk profile and determining the capital required to withstand adverse scenarios, considering factors like financial strength and expected losses. Credit ratings issued by agencies like S&P, Moody's, and Fitch play a crucial role in assessing entities' creditworthiness and financial strength.

Economic Capital has certain benefits associated with - enhanced capital allocation, regulatory compliance, and improved risk assessment. Nevertheless, the negatives also entail – calculations complexity, subjective inputs, and data limitations. Moreover, its implications include the following:

• Optimal capital deployment
• Informed decision-making
• And a solid foundation stone for strategic planning

Therefore, it has a variety of applications in the financial industry, such as:

• Risk-based pricing
• Stress testing
• Capital optimization 

In the realm of finance, several performance measures take into account economic capital, such as:

• Return on Risk-Adjusted Capital (RORAC),
• Return on Risk-Weighted Assets (RORWA), and
• Economic Value Added (EVA).

Moreover, these measures assist management in evaluating business lines and identifying areas where capital allocation can be optimized. Therefore, by focusing on these businesses, companies can enhance their financial performance and efficiently use their available capital.

In addition, return on economic capital is a performance metric that measures the profitability and efficiency of a company concerning the capital it has allocated to support risks and uncertainties.

A generalized formula for the calculation of EC can be given:

Economic Capital = Value at risk (total risk amount) -  Expected Losses

Where:

Total risk amount = (Credit risk + insurance risk + liquidity risk + operations risk)

Expected losses = total losses plus a firm's obligation, including future losses from various risks, contractual obligations, and debts.

Let us use a few examples to understand the topic.

Example #1

Suppose a fictitious entity ABC Manufacturing functions in the manufacturing industry. Here, ABC Manufacturing would like to calculate its economic capital to find whether it has the needed financial resilience & risk-absorbing ability to thwart future losses. It has the following data:

Total Risk Amount: $10 million -------------- (1)

Expected losses: $6 million -------------------- (2)

Hence, we shall use the above data in the economic capital formula and calculate EC as follows:

Economic Capital = Value at risk (total risk amount) -  Expected Losses

                                 = (1)-(2)

                             = 10-6= $4 million 

Therefore, ABC Manufacturing's EC = $4 million

Hence, one can infer from the above that ABC Manufacturing:

• Has enough EC to fight any risk 
• Has enough capital to remain stable during financial adversity

Example #2

Let us say a startup has an initial capital of one lakh dollars for covering its initial expenses like marketing, inventory, and equipment. Thus such startup capital acts as its economic capital because:

• It will be its safety net in financial turbulence
• It will allow it to stand on its own during financial losses
• And it provides capital to invest in new projects

Let us use the table below to understand the difference between EC and regulatory capital, and financial capital:

Let us use the table below to understand the differences between the two:

This article has been a guide to what is Economic Capital. Here, we explain it with its examples, comparison with regulatory and cultural capital, and formula. You may also find some useful articles here -

• Capitalist Economy
• Capital Receipts
• Capital Inflow