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
A going concern is a business that is assumed will meet its financial obligations when they become due. It functions without the threat of liquidation for the foreseeable future, which is usually regarded as at least the next 12 months or the spec ...
, 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 most ...
,
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
Basel II classified legal risk as a subset of operational risk in 2003. This conception is based on a business perspective, recognizing that there are threats entailed in the business operating environment. The idea is that businesses do not ...
, 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
In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
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
Phoenicia () was an ancient thalassocratic civilization originating in the Levant region of the eastern Mediterranean, primarily located in modern Lebanon. The territory of the Phoenician city-states extended and shrank throughout their histor ...
, 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 ...
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.
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In social science
In
social science
Social science is one of the branches of science, devoted to the study of societies and the relationships among individuals within those societies. The term was formerly used to refer to the field of sociology, the original "science of so ...
, ''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 ...
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 be ...
. These forms of capital include
natural capital
Natural capital is the world's stock of natural resources, which includes geology, soils, air, water and all living organisms. Some natural capital assets provide people with free goods and services, often called ecosystem services. All of t ...
,
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 relatio ...
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, priva ...
society
A society is a group of individuals involved in persistent social interaction, or a large social group sharing the same spatial or social territory, typically subject to the same political authority and dominant cultural expectations. Soci ...
via formal education or through social ties. Non-economic forms of capital have been variously discussed most famously by sociologist
Pierre Bourdieu
Pierre Bourdieu (; 1 August 1930 – 23 January 2002) was a French sociologist and public intellectual. Bourdieu's contributions to the sociology of education, the theory of sociology, and sociology of aesthetics have achieved wide influence ...
.
See also
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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 t ...
*
Basel I
Basel I is the first Basel Accord. It arose from deliberations by central bankers from major countries during the late 1970s and 1980s. In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum ...
*
Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III.
The Basel II Accord was publ ...
*
Capital structure
*
Financial risk management
*
Financial services conglomerate
*
RAROC, risk-adjusted return on capital
*
RORAC, return on risk-adjusted capital
*
Solvency II
Solvency II Directive 20092009/138/EC is a Directive in European Union law that codifies and harmonises the EU insurance regulation. Primarily this concerns the amount of capital that EU insurance companies must hold to reduce the risk of insolv ...
References
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*
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External links
FDIC.gov Economic Capital and the Assessment of Capital Adequacy
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC) is one of two agencies that supply deposit insurance to depositors in American depository institutions, the other being the National Credit Union Administration, which regulates and insures cr ...
BIS.org "Basel Committee, Bank for International Settlements"
Economic Capital - A PreambleCEIOPS"
{{Sociology-stub
Actuarial science
Financial risk