Background on Economic Capital

John S Walter

Institutions using economic capital methodology have coined the term to distinguish it from other measures of capital adequacy – in particular, regulatory and accounting concepts of capital. The term economic also encapsulates an ambition, like that of the dismal science, to describe and measure on a consistent basis the range of phenomena that drive a bank’s risk/return decisions. A consistent and comprehensive economic model accomplishes two goals:

1. It provides a common currency of risk that management can use to compare the risk-adjusted profitability and relative value of businesses with widely varying degrees and sources of risk.

2. It allows bank management and supervisors to evaluate overall capital adequacy in relation to the risk profile of the institution.

With increasing dialogue among practitioners, regulators, and academics, best practices have gradually emerged, setting standards for calculation in most aspects of economic capital. Advances continue, especially in the areas of operational risk and consumer credit risk, but the overall field has matured to the point where supervisors have begun, with the upcoming implementation of the New Basel Capital Accord