Introduction

Ashish Dev

Economic capital is a measure of risk. It is a single measure that captures unexpected losses or reduction in value or income from a portfolio or business in a financial institution. The risk arises from the unexpected nature of the losses as distinct from expected losses, which are considered part of doing business and are covered by reserves and income. Economic capital covers all unexpected events except the catastrophic ones, for which it is impossible to hold capital. Economic capital is a common currency in which all risks of a financial institution can be measured, enabling comparison of risk across different risks, across diverse businesses and across different financial institutions. A precise definition of economic capital is not attempted in this Introduction, since such a definition can be found in more than one place in the book.

The most important conceptual distinction between expected loss and unexpected loss is that the expected loss of a portfolio is simply the sum of expected losses for each of the constituent transactions within the portfolio. In that sense, expected loss is similar to variables such as revenue and expense. But the same does not hold true for