The Significance of Economic Capital to Financial Institutions

Vandana Rao

Economic capital (EC) is a relatively new concept. Although some of its roots can be traced to the 1980s, EC was introduced in financial institutions in the 1990s and has evolved into significant practical importance only in the last decade or so. A precise definition will be attempted later in the chapter. As an introduction, EC is a dollar number that serves as a common measure across all types of financial risks and captures the risk of unexpected losses or unexpected reductions in income in a business, a portfolio or a single transaction. EC is necessarily calculated at a portfolio level and attributed to each transaction within the portfolio.

Capital investments in an industrial organisation are on physical plant, machinery and equipment. Therefore, it is relatively easy to assign specific capital investments to particular project or business unit within the corporation. As a result, deriving the capital associated with a project is very tractable. All the focus then falls on deriving the appropriate discount rate for NPV calculation. By contrast, in a financial institution, there is little physical capital investment. Deriving the capital associated with a product or a