'Economic Capital' is a term that is often used within financial portfolio risk management to represent a quantitative measure of the amount of capital that would be required to cover the potential losses that might be incurred by a risky portfolio of financial exposures - for example credit exposures, such as corporate loans.

Different approaches vary from what are essentially 'rules of thumb', based on empirical observations and experience, through to complex statistical risk models.

Many banks and financial institutions have been using variants of these models for quite some time, and the Basel-2 accord raised their status within the context of the regulatory oversight framework for capital adequacy and risk management.

• See our on-line presentation: An Introduction to Economic Capital

“Determination of appropriate capital levels is not just a regulatory concern. Increasingly, bankers are treating the determination of proper capital levels as integral to the meeting of shareholder goals. Shareholder value is maximized, almost surely, when long run risk adjusted return on equity is maximized”

Alan Greenspan, 18 November 1996.
In a speech given to the Federation of Bankers' Association of Japan.

The Different Types of Economic Capital Model

The simpler models which are essentially based on 'rules of thumb' - and often bucket exposures into different categories, with prescribed capital treatments for each. These also usually include conservative constraints on the types of risk mitigation that can be used in the calculations.

More complex 'statistical models' use mathematical techniques to compute Portfolio Risk Statistics that are useful measures for risk - often based on probability distributions that are computed internally by these models.

In our view both of these approaches have a role to play, and can usefully be used together - it is not necessarily the case that more complex models are always necessarily 'better' - much depends on how and where they are used. Indeed, in the wrong hands, more complex portfolio risk models can be misused and misunderstood more easily.

To get an insight into of some of the problems that can be encountered by the unwary or inept when using sophisticated Economic Capital models, see some of the posts in our Risk Commentary: