Economic Capital
It is a measure of the risk associated with capital investment.
Updated:
September 15, 2022Economic capital is a measure of the risk associated with capital investment. For example, an organization (usually one in the financial services industry) needs a certain amount of capital to maintain its financial stability.
In essence, it refers to the amount of capital required to guarantee the firm's liquidity, determined by the amount of risk that can be attributed to the assets and operations of the firm.
An organization can determine its profit-making by using proprietary models. Furthermore, the number resulting from this calculation is also the amount of capital an organization should have to support any risks it takes.
A financial company usually generates profit internally using forecasts and estimates. Using this method, the company calculates how much capital it should keep in reserve to accommodate risks and stresses.
It is essential to distinguish between economic capital and regulatory capital (also called capital requirements); the two should not be confused.
Financial organizations use profit-making to measure and report market and operational risks. However, in contrast to accounting and regulatory rules, which can sometimes be misleading, profit-making measures risk using economic realities.
Consequently, financial capital represents a firm's solvency more realistic.
A company's financial capital determines its ability to survive any risks it may face. Essentially, it is an assessment of risk. Companies in the financial services industry calculate their economic capital internally.
It is measured by converting a given risk into the amount of capital required to support it. These calculations are based on the institution's financial strength (or credit rating) and the probability of losing money.
Firms expect their loss to be the average loss over the measurement period. A company's expected losses are a cost of doing business and are usually offset by profits.
Economic Capital (EC) Basics
Banks, insurers, and other entities providing financial services use economic capital. Financial services companies also measure and gauge their operational and market risks.
In contrast to accounting and regulatory rules, business capital captures the inherent risk of the economic environment. It is therefore considered to be a more accurate measure of the solvency of a financial service company.
To measure profitability, it is necessary to assess the probability of a company's risk and the amount of capital it will require in the event of an adverse scenario.
A financial institution's expected losses and financial strength are factored into the calculations.
A firm's financial strength includes its probability of default. This type of information is usually represented as a credit rating, an assessment of a person's or entity's creditworthiness.
Three central credit rating agencies give credit ratings to publicly traded companies:
- Standard and Poor's (S&P)
- Moody's
- Fitch
The financial strength metric measures the probability that a company won't default over time. The probability is used in the statistical calculation of confidence levels.
Losses expected over a period are the average loss for that period. They include costs associated with doing business as well as unexpected losses.
Banks, for example, might expect losses if borrowers default on their loans. Similarly, insurance companies may have expected losses from claims.
To make informed decisions, the risk and reward profiles should consider profit-making. Money making, for instance, may influence a bank's decision to pursue certain business lines.
If a bank has robust monetary capital, the management can decide to make riskier loans and pursue more volatile operational activities such as the capital markets (investment banking, sales, trading, etc.).
If a bank discovers that its business capital is weak, it might decide to make safer loans and pursue less volatile business lines, such as retail banking or wealth management.
It can be accounted for in several performance measures, such as:
- Return on Risk-Adjusted Capital (RORAC)
- Return on Risk-Weighted Assets (RORWA)
- Economic Value Added (EVA)
Business lines that can optimize measures are evaluated by management, and capital allocations are dedicated to these businesses.
The Uniqueness of Financial Services Companies
Assets and productivity are essential for financial services companies because of the unique business models that these companies employ.
It is common for companies to sell a product or service in exchange for money and make profits. However, in reality, financial firms will use the money and manipulate the allocation and timing of cash flows to generate profits.
Banks, for example, follow unique business models in which they do not manufacture or sell anything as their core business. Instead, individuals or other entities deposit money with them rather than giving them direct loans.
In exchange for depositing their money with an institution, the depositors earn an interest rate.
The bank then lends the funds to entities and charges a higher interest rate to profit from the spread between the depositors' interest rate and the lender's interest rate.
The risks associated with such a business model are unique as well. First, there is a significant risk that many depositors will want to withdraw their funds all at once.
This is mitigated by ensuring the bank keeps a certain amount of capital to remain solvent and repay its depositors.
Banks are routinely exposed to the risk of defaults, which result in a low impact on the overall operation. But, at the same time, the bank must be prepared to deal with catastrophic losses and events, like recessions and market crashes.
These events are factored into internal forecasts of profit-making.
Calculation
As mentioned in previous sections, it can be described as the amount of capital an institution needs to maintain to absorb the impact of unexpected losses at a certain level of confidence throughout a time horizon.
Several approaches to calculating have been proposed; the main one's a top-down and a bottom-up approach.
1. Top-down Approach
When using top-down approaches, profit-making at the enterprise level can be calculated using the aggregated performance measures at the company's level. The information used can either be Earnings Volatility or Stock Price Volatility.
Earnings volatility is a model that assumes the value of capital equals the value of the perpetual earnings stream.
Earnings are represented as Expected Earnings/k, where expected earnings represent the 'expected earnings of the next period,' and k is the required 'rate of return.'
If we are interested in calculating the remunerative, which is the capital required to sustain worst-case losses, we can calculate the EC with the formula:
EC = EaR / k
where,
EaR: denotes Earnings at Risk as far as the expected and worst-case earnings are concerned, and
k: is the required 'rate of return,' as stated above.
In this approach, there is a problem in that very few companies have sufficiently reliable data which can help determine an appropriate measure of equity return.
Also, the EC calculated in this manner does not have a direct relationship with the measured risks. As a result, this approach makes it difficult to segregate capital for credit, market, and operational risks.
An alternative method of calculating capital value is based on the Black-Scholes Model, which is based on stock prices.
This approach may be conceptualized as a call option on the value of a firm's debt, under which the value of capital can be conceived as an asset.
If the value of assets exceeds the value of debt of a company, the capital will be equal to the difference between the value of the assets and the value of the debt.
Regardless of the worst-case scenario, the EC required for a firm to remain solvent can be calculated using the BSM (Black-Scholes model), considering the level of debt needed.
Using this method, we take advantage of the company's readily available stock price information.
2. Bottom-up Approach
Bottom-up approaches assume that each transaction and business unit is modeled independently of the others. Then the risk is grouped using statistical models so the EC value can be calculated.
It is preferable to use this approach rather than top-down since it offers a high level of transparency and allows for the location of credit and market risk separately from operational risk.
The firm uses VaR models to calculate individual risks and then calculate capital allocated across these risks.
Credit risk capital, market risk capital, and operational risk capital are commonly added together when calculating credit risk capital.
Examples
Following are a few examples of different types of capital:
1. Financial (Economic) Capital
A business needs to have access to finance to get off the ground and grow. Two types of capital, debt and equity, can be used to finance a business.
The concept of debt capital refers to borrowing funds that must be repaid, usually with interest, in the future.
The most common forms of debt capital include:
- bank loans
- personal loans
- overdraft agreements
- credit card debt
A company's equity capital refers to the funds generated by the sale of stock, either common stock or preferred stock. Even though investors do not need to recoup the funds, they expect a specific rate of return on their investments.
As well as in the form of cash, economic capital may also appear in the form of other assets such as real estate, commodities, equipment, vehicles, and so forth, which can be traded for cash in the market.
2. Human Capital
While human capital is less tangible, its contribution to a company's success cannot be underestimated. Human capital consists of the skills and abilities employees of a company contribute to its operation.
Even though most companies have difficulty quantifying human capital in dollars, they know that continuing education courses, professional development seminars, and healthy-living programs can significantly enhance employee performance.
Many businesses invest in employee happiness and well-being to cultivate a more efficient and happier workforce. This investment indirectly benefits the bottom line by cultivating a more engaged and satisfied workforce.
3. Social Capital
An even more intangible asset is social capital, which refers to the connections that people have with each other and the desire they must do things for and with other people in their social circles.
There seems to be a tendency for individuals to give to those in their social network, creating a cycle of mutually beneficial reciprocity.
In the context of an individual's social network, social capital refers to the content of the relational ties between people and is not a product of the other network members but is the result of the members' social capital.
If, for example, you have a wealthy uncle, and you know he could lend you some money if you need it, this is a way of leveraging the social capital embedded in your relationship.
A person with a high level of social capital is likely to know many influential people within their industry and may have more opportunities for advancement and development than someone with a small social circle.
Additionally, individuals with higher levels of social capital may have an easier time attaining things, both personally and professionally, because they can draw upon the strengths and resources of their social networks.
Aside from social capital, there are various types of capital that sociologists and anthropologists have identified.
This includes capital such as symbolic capital, including the honor and status associated with a credential or a promotion, and cultural capital, such as race, nationality, religious belief, and so on.
Being able to recognize and appreciate things of high class, like fine art or fine food, while distinguishing these things from more mundane items.
4. Capital and Capitalism
Capitalism, at its fundamental level, requires that capital be separated from the labor used to produce goods and services.
For example, a business owner and their investors (which constitute the capitalists) jointly own all the company's assets, raw materials, equipment, and final product.
This means that capitalists are also entitled to 100% of the profits from selling goods on the market.
The capitalist exploits his equipment and raw materials (factories, money, tools, vehicles, etc.) and then hires workers, known generally as labor, to use these tools and materials to assemble and finish a final product in exchange for a salary.
It is important to remember that labor owns none of the tools used to make the equipment, none of the raw materials that went into making it, and not one of the finished products.
This means they also have no rights to any profits from selling those products. The only thing they get is their salary.
In reality, modern businesses do not just consist of owners and investors but also include a layer of managers (well-paid employees) and the employees they supervise.
Along this entire path of leveraging EC, human capital, and social capital, profits and productivity will increase.
5. Economic Capital
For example, a bank may want to assess the risk profile of its loan portfolio over the next year.
In particular, the bank seeks to determine how much economic capital is needed to absorb a loss approaching the 0.04% mark in the loss distribution, which is a 99.96% confidence interval.
The bank calculates a 99.96% confidence interval that multiplies economic capital by $1 billion beyond the anticipated (average) loss.
When a bank does not have enough economic capital, it may take measures such as raising capital or increasing underwriting standards for its loans to maintain its credit rating.
It could further break down its loan portfolio to determine whether the bank's mortgage portfolio is riskier than its loan portfolio.
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