Confidence crunch

Many financial institutions calibrate their required level of economic capital by considering the probability of default associated with a target debt rating. However, as the financial crisis has shown, confidence in a bank can erode before its Tier I capital ratio reaches the established minimum level. Tony Rich argues banks need to move beyond solvency-based measures of economic capital in the internal capital adequacy assessment process

The term ‘economic capital’ describes the collection of practices used to measure the economic effects of risk-taking activities that give rise to losses. One of the central challenges in translating this simple conceptual definition into a practical measure of risk is to determine exactly how much uncertainty the bank should be able to absorb. It is clearly not possible to cover every single combination of unexpected loss, so the level of capital held must be set by reference to a chosen risk