Economic Capital

What Is Economic Capital?

Economic capital is a key measure of risk in finance, determining the necessary capital for stability based on asset and operational risks. It guides resource allocation and proactive risk management in a dynamic financial environment.

Unlike static regulations, economic capital adjusts with market changes, aiding organizations in strategic resilience and understanding their specific risk landscape. It's a crucial tool for financial stability and strategic planning. Some key points related to economic capital are as follows: 

1. Determining Profitability

Organizations employ proprietary models to calculate profit, which also serves as the required capital to support undertaken risks. Internal forecasting and estimates guide financial companies in determining the capital needed to cushion against potential risks and stresses.

2. Economic and Regulatory Capital

It is vital to differentiate economic capital from regulatory capital (capital requirements) to avoid confusion. While regulatory capital adheres to accounting and regulatory rules, economic capital measures risks using more realistic economic realities.

3. Realistic Assessment of Solvency

Financial capital or Economic capital, as a measure of solvency, realistically determines a company's ability to withstand risks it may encounter. 

Companies in the financial sector internally calculate economic capital, converting specific risks into the required capital amount based on financial strength and probability of losses.

4. Risk Measurement and Reporting

Profit-making is utilized by financial organizations to measure and report market and operational risks. In contrast to potentially misleading accounting and regulatory rules, profit-making aligns more closely with economic realities, offering a more accurate representation of a firm's solvency.

5. Calculation Methodology

Economic capital calculations involve converting risks into the necessary capital, relying on the institution's credit rating and the probability of monetary loss. 

Firms anticipate average losses over a measurement period, considering them as a cost of doing business that is typically offset by profits.

Understanding Economic Capital

Banks, insurers, and other entities providing financial services use economic capital. Financial services companies also measure and gauge their operational and market risks.

In contrast to accounting and regulatory rules, business capital captures the inherent risk of the economic environment. It is therefore considered to be a more accurate measure of the solvency of a financial service company.

To measure profitability, it is necessary to assess the probability of a company's risk and the amount of capital it will require in the event of an adverse scenario. A financial institution's expected losses and financial strength are factored into the calculations.

A firm's financial strength includes its probability of default. This type of information is usually represented as a credit rating, an assessment of a person's or entity's creditworthiness. Three central credit rating agencies give credit ratings to publicly traded companies: 

1. Standard and Poor's (S&P) 
2. Moody's
3. Fitch

The financial strength metric measures the probability that a company won't default over time. The probability is used in the statistical calculation of confidence levels.  Losses expected over a period are the average loss for that period. They include costs associated with doing business as well as unexpected losses. 

Banks, for example, might expect losses if borrowers default on their loans. Similarly, insurance companies may have expected losses from claims. To make informed decisions, the risk and reward profiles should consider profit-making.

If a bank has robust monetary capital, the management can decide to make riskier loans and pursue more volatile operational activities such as the capital markets (investment banking, sales, trading, etc.).

If a bank discovers that its business capital is weak, it might decide to make safer loans and pursue less volatile business lines, such as retail banking or wealth management. It can be accounted for in several performance measures, such as:

• Return on Risk-Adjusted Capital (RORAC)
• Return on Risk-Weighted Assets (RORWA)
• Economic Value Added (EVA)

Business lines that can optimize measures are evaluated by management, and capital allocations are dedicated to these businesses.

The Uniqueness of Financial Services Companies

Financial services companies rely on assets and productivity due to their distinctive business models. While conventional companies sell products or services for profits, financial firms strategically manipulate cash flow allocation and timing to generate their earnings.

Banks, for example, follow unique business models in which they do not manufacture or sell anything as their core business. Instead, individuals or other entities deposit money with them rather than giving them direct loans.

In exchange for depositing their money with an institution, the depositors earn an interest rate. The bank then lends the funds to entities and charges a higher interest rate to profit from the spread between the depositors' interest rate and the lender's interest rate.

There is a significant risk that many depositors will want to withdraw their funds all at once.  This is mitigated by ensuring the bank keeps a certain amount of capital to remain solvent and repay its depositors.

Banks are routinely exposed to the risk of defaults, which result in a low impact on the overall operation. But, at the same time, the bank must be prepared to deal with catastrophic losses and events, like recessions and market crashes. 

Economic Capital Calculation

As mentioned in previous sections, it can be described as the amount of capital an institution needs to maintain to absorb the impact of unexpected losses at a certain level of confidence throughout a time horizon.

Several approaches to calculating have been proposed; the main one's a top-down and a bottom-up approach.

1. Top-down Approach

When using top-down approaches, profit-making at the enterprise level can be calculated using the aggregated performance measures at the company's level.

The information used can either be Earnings Volatility or Stock Price Volatility. Earnings volatility is a model that assumes the value of capital equals the value of the perpetual earnings stream. 

If we are interested in calculating the remunerative, which is the capital required to sustain worst-case losses, we can calculate the EC with the formula:

EC = EaR / k

Where, 

• EaR: denotes Earnings at Risk as far as the expected and worst-case earnings are concerned, and
• k: is the required 'rate of return,' as stated above.

Few companies have reliable data for determining equity return measures in this approach. The calculated Economic Capital (EC) lacks a direct correlation with measured risks, complicating capital segregation for credit, market, and operational risks.

If the value of assets exceeds the value of debt of a company, the capital will be equal to the difference between the value of the assets and the value of the debt.  

Regardless of the worst-case scenario, the EC required for a firm to remain solvent can be calculated using this model, considering the level of debt needed. Using this method, we take advantage of the company's readily available stock price information.

2. Bottom-up Approach

Bottom-up approaches assume that each transaction and business unit is modeled independently of the others. Then the risk is grouped using statistical models so the EC value can be calculated. 

It is preferable to use this approach rather than top-down since it offers a high level of transparency and allows for the location of credit and market risk separately from operational risk. 

The firm uses VaR models to calculate individual risks and then calculate capital allocated across these risks. 

Credit risk capital, market risk capital, and operational risk capital are commonly added together when calculating credit risk capital.

Economic Capital Examples

Following are a few examples of different types of capital:

1) Financial (Economic) Capital

A business needs to have access to finance to get off the ground and grow. Two types of capital, debt and equity, can be used to finance a business. 

The concept of debt capital refers to borrowing funds that must be repaid, usually with interest, in the future.

The most common forms of debt capital include:

1. bank loans
2. personal loans
3. overdraft agreements
4. credit card debt 

A company's equity capital refers to the funds generated by the sale of stock, either common stock or preferred stock. Even though investors do not need to recoup the funds, they expect a specific rate of return on their investments.

Apart from cash, economic capital may also appear in the form of other assets, such as real estate, commodities, equipment, vehicles, and so forth, which can be traded for cash in the market.

2) Human Capital

While human capital is less tangible, its contribution to a company's success cannot be underestimated. Human capital consists of the skills and abilities employees of a company contribute to its operation.

Even though most companies have difficulty quantifying human capital in dollars, they know that continuing education courses, professional development seminars, and healthy-living programs can significantly enhance employee performance.

Many businesses invest in employee happiness and well-being to cultivate a more efficient and happier workforce. This investment indirectly benefits the bottom line by cultivating a more engaged and satisfied workforce.

3) Social Capital

An even more intangible asset is social capital, which refers to the connections that people have with each other and the desire they must do things for and with other people in their social circles. There seems to be a tendency for individuals to give to those in their social network, creating a cycle of mutually beneficial reciprocity. 

In the context of an individual's social network, social capital refers to the content of the relational ties between people and is not a product of the other network members but is the result of the members' social capital. 

Additionally, individuals with higher levels of social capital may have an easier time attaining things, both personally and professionally, because they can draw upon the strengths and resources of their social networks.

Aside from social capital, there are various types of capital that sociologists and anthropologists have identified. This includes capital such as symbolic capital, including the honor and status associated with a credential or a promotion, and cultural capital, such as race, nationality, religious belief, and so on. 

4) Capital and Capitalism

Capitalism, at its fundamental level, requires that capital be separated from the labor used to produce goods and services. 

For example, a business owner and their investors (which constitute the capitalists) jointly own all the company's assets, raw materials, equipment, and final product. This means that capitalists are also entitled to 100% of the profits from selling goods on the market.

The capitalist exploits his equipment and raw materials (factories, money, tools, vehicles, etc.) and then hires workers, known generally as labor, to use these tools and materials to assemble and finish a final product in exchange for a salary. 

It is important to remember that labor owns none of the tools used to make the equipment, none of the raw materials that went into making it, and not one of the finished products. This means they also have no rights to any profits from selling those products. The only thing they get is their salary.

Modern businesses extend beyond owners and investors to include managers and employees. By leveraging economic, human, and social capital, this integrated approach enhances profits and boosts productivity.

conclusion

Economic capital is pivotal in finance, guiding strategic risk management and ensuring stability amid market fluctuations. Its adaptability to changing economic conditions allows for effective resource allocation, essential for maintaining solvency and profitability.

Through varied calculation methods, institutions assess risks and determine necessary capital, aiding informed decision-making for solvency and resilience.

Ultimately, economic capital fosters financial stability and resilience, enhancing the ability of an organization to navigate risks for sustainable growth and success.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capital Deepening
• Circular Flow Model
• Financial Economics
• Helicopter Money
• Liquidity Trap