Chapter 6

Economic Capital Simplified

Economic capital is the amount of money a financial institution
needs to hold to cover the risks it faces. In simple terms, it's the
money required to survive very bad situations. If a bank's
available capital is more than its economic capital, it can handle
big problems without going under.
Economic capital is crucial for managing money and following
regulations, so we discuss it early in this book. Even without
regulations, financial institutions would still use economic capital
because it helps manage risks. Traders were using the concept of
economic capital, often called Value at Risk (VaR), before any
regulations required it.
Why is economic capital so important for financial institutions?
And why don't non-financial companies focus on it as much?
Some non-financial companies do try to figure out how much
money they would need for big, unexpected problems. But no
industry cares about economic capital as much as the financial
industry. This is because managing risks is the core business of
financial institutions, while non-financial companies focus on
making sure risks don’t seriously harm their operations.
Here are a few reasons why financial institutions pay more
attention to economic capital:
1. High Leverage: Financial institutions use a lot of borrowed
money to increase returns. This leverage can amplify profits, but
it also increases risks. Even small negative impacts can wipe out
their capital, making it essential to manage risks closely.
2. Risk Management: For financial institutions, managing risks
isn't just important—it’s their main business. They need to
identify, measure, and manage all risks to avoid bankruptcy. Non-
financial companies, on the other hand, manage risks to ensure
their business runs smoothly but don't rely on it as their core
function.
In summary, economic capital is a vital measure for financial
institutions due to their high leverage and the central role of risk
management in their operations. Non-financial companies
manage risks too, but not with the same intensity or focus.
How to Measure Economic Capital
Now that we understand why financial institutions need economic
capital, the next question is: How do we measure it, and what
affects it? Measuring economic capital isn't exact, similar to how
you can't precisely predict the outcome if someone is hit by a car.
Even though it's not an exact science, it's still important to try and
measure economic capital using as much information and
experience as possible. It's also important to remember that any
calculated number is just an estimate. That's why economic
capital should be used alongside other tools, like stress tests, to
manage risks and make decisions.
Economic capital involves assigning a probability to each
possible loss (or gain). Since you can't attach a probability to one
specific outcome, you usually try to estimate the probability that
any loss in a given year will be smaller than a certain amount.
This involves looking at all types of risks (market risk, credit risk,
operational risk, etc.) and creating a probability distribution that
shows different loss amounts and their associated probabilities.
Once this distribution is plotted, a financial institution can decide
its economic capital based on a confidence level. For example, if
a bank wants to be secure in 99.9% of cases, it needs to have
enough capital so that there's only a 0.1% chance of losses
exceeding that amount.
In simpler terms, economic capital is the loss amount Y that a
financial institution can absorb in X% of cases. The higher the
confidence level (X%), the more capital is needed. For example,
to achieve a higher credit rating, a bank needs to be able to absorb
losses in a larger percentage of cases. If aiming for a single A
rating, it needs to cover losses in 99.90% of cases over a year. For
a triple A rating, it needs to cover losses in 99.99% of cases.
To summarize, economic capital depends on the confidence
level a financial institution wants to achieve. The higher the
desired confidence level, the more capital is needed to cover
potential losses.
Adjusting Economic Capital for Higher Credit Ratings
Let's say a financial institution, F, has determined the distribution
of its potential losses. For 99.90% of the time, losses are less than
$1 billion. To get a single A rating, F needs to have $1 billion in
capital.
However, F wants a double A (AA) rating. This means it needs
enough capital to cover losses in 99.97% of cases over a year. For
this higher confidence level, the loss amount increases to $1.5
billion. Since F currently has only $1 billion, it needs an
additional $0.5 billion in capital to reach an AA rating.
If F doesn't want to raise more capital, it must reduce its risks so
that the maximum loss in 99.97% of cases is $1 billion. This way,
F can achieve the AA rating without needing extra capital.
Understanding Economic Capital and Risk Diversification
When calculating economic capital, a financial institution must
consider all types of risks it faces. This involves creating a
combined loss distribution that includes market risk, credit risk,
and other types of risks. To do this, you need to make assumptions
about how these risks are correlated. These correlations are never
exact, but experience can provide some guidance. It's important
to consider how these risks interact in both normal and stressful
times. If correlations are close to 1, there's little diversification,
meaning risks are almost fully additive. Lower or negative
correlations suggest more diversification, where risks may offset
each other.
Another key issue is determining the shape of the loss
distribution. This is complex and can be based on different
assumptions, such as assuming normally distributed returns or
other models. Because of these assumptions, economic capital is
not a precise number but an estimate.
Types of Losses in Economic Capital Calculation
Consider a bank, Bank Z, which owns $1 billion in corporate
bonds. The type of losses you include in your calculations can
significantly affect the economic capital needed.
1. Market Risk: If the bank is looking at market price
movements, the economic capital with 99.90% confidence over a
year might be $0.4 billion due to high market price volatility.

2. Credit Risk: If the bank is focusing on credit risk (the risk of

defaults), the economic capital needed with the same confidence
level might only be $0.1 billion.
The accounting treatment of these bonds also matters. If the bonds
are marked as "available for sale," market value changes do not
impact profit and loss statements or regulatory capital. Negative
revaluation reserves from interest-bearing securities are excluded
from regulatory capital. So, for regulatory purposes, $0.1 billion
might be sufficient to cover credit risk. However, rating agencies,
which focus on IFRS equity, might consider the $0.4 billion
market risk figure more relevant because IFRS equity includes
these revaluation reserves.
Importance of Stakeholder Analysis
Different stakeholders (regulators, rating agencies, etc.) view
risks differently, which is why it’s crucial to perform a
stakeholder analysis when managing capital. Regulators might be
satisfied with lower economic capital based on credit risk, while
rating agencies might demand higher economic capital based on
market risk.
By understanding and addressing these perspectives, financial
institutions can better manage their capital to meet various
expectations and requirements.