What Is Economic Capital (EC)?
Economic Capital (EC) refers to the amount of financial resources a company needs to absorb potential losses due to the risks and uncertainties within its operations. It has multiple purposes, like measuring the risk-taking capacity, aiding in risk management decisions, plus ascertaining the correct amount of capital to fight adverse events.
EC plays a key role in measuring the overall sturdiness of an organization using factors like operational risk, liquidity risk, market risk, and credit risk. Thus, it helps in allocating capital amongst different business units, compliance with regulatory requirements, and evaluating the success of new investments. A firm with adequate EC protects it from financial problems plus potential risks, promotes stakeholders‘ confidence, and anchors its long-term sustainability.
Table of contents
- Economic Capital (EC) refers to the number of financial resources needed to absorb potential losses due to risks and uncertainties within a firm, serving multiple purposes such as measuring risk-taking capacity, aiding in risk management decisions, and determining the appropriate capital required to withstand adverse events.
- Its formula involves subtracting the expected liabilities and the capital buffer from the total assets.
- It represents the net financial resources, including securities, equity, and debt, needed to withstand losses from uncertainties and risks within a firm. In contrast, regulatory capital represents the minimum mandated capital amount set by regulatory authorities to ensure financial stability and solvency.
- Economic capital represents the financial resources required to withstand losses from uncertainties and risks within a firm. In contrast, cultural capital encompasses non-financial assets.
Economic Capital Explained
Economic capital can be defined as a metric utilized to quantify the amount of capital a company needs to withstand financial stress, litigation, or risks associated with future uncertainties. Thus, it helps in determining a company’s risk-taking ability and financial resilience. It came to the fore in the nineties when financial institutions began increasing risk management practices.
Furthermore, financial institutions such as banks and insurance companies depend on economic capital generated internally through estimations and forecasting models. This capital represents the amount necessary to support risks and uncertainties, providing a more accurate measure of a company’s solvency than regulatory and accounting rules.
As per the definition of economic capital, its assessment involves evaluating the company’s risk profile and determining the capital required to withstand adverse scenarios, considering factors like financial strength and expected losses. Credit ratings issued by agencies like S&P, Moody’s, and Fitch play a crucial role in assessing entities’ creditworthiness and financial strength.
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Benefits And Applications
Economic Capital has certain benefits associated with – enhanced capital allocation, regulatory compliance, and improved risk assessment. Nevertheless, the negatives also entail – calculations complexity, subjective inputs, and data limitations. Moreover, its implications include the following:
- Optimal capital deployment
- Informed decision-making
- And a solid foundation stone for strategic planning
Therefore, it has a variety of applications in the financial industry, such as:
- Risk-based pricing
- Stress testing
- Capital optimization
In the realm of finance, several performance measures take into account economic capital, such as:
- Return on Risk-Adjusted Capital (RORAC),
- Return on Risk-Weighted Assets (RORWA), and
- Economic Value Added (EVA).
Moreover, these measures assist management in evaluating business lines and identifying areas where capital allocation can be optimized. Therefore, by focusing on these businesses, companies can enhance their financial performance and efficiently use their available capital.
In addition, return on economic capital is a performance metric that measures the profitability and efficiency of a company concerning the capital it has allocated to support risks and uncertainties.
A generalized formula for the calculation of EC can be given:
Economic Capital = Value at risk (total risk amount) – Expected Losses
Total risk amount = (Credit risk + insurance risk + liquidity risk + operations risk)
Expected losses = total losses plus a firm’s obligation, including future losses from various risks, contractual obligations, and debts.
Let us use a few examples to understand the topic.
Suppose a fictitious entity ABC Manufacturing functions in the manufacturing industry. Here, ABC Manufacturing would like to calculate its economic capital to find whether it has the needed financial resilience & risk-absorbing ability to thwart future losses. It has the following data:
Total Risk Amount: $10 million ————– (1)
Expected losses: $6 million ——————– (2)
Hence, we shall use the above data in the economic capital formula and calculate EC as follows:
Economic Capital = Value at risk (total risk amount) – Expected Losses
= 10-6= $4 million
Therefore, ABC Manufacturing’s EC = $4 million
Hence, one can infer from the above that ABC Manufacturing:
- Has enough EC to fight any risk
- Has enough capital to remain stable during financial adversity
Let us say a startup has an initial capital of one lakh dollars for covering its initial expenses like marketing, inventory, and equipment. Thus such startup capital acts as its economic capital because:
- It will be its safety net in financial turbulence
- It will allow it to stand on its own during financial losses
- And it provides capital to invest in new projects
Economic Capital vs Regulatory Capital vs Financial Capital
Let us use the table below to understand the difference between EC and regulatory capital, and financial capital:
|Economic Capital||Regulatory Capital||Financial capital|
|It represents the amount of financial resources needed to withstand losses from uncertainties and risks within a firm.||It represents the minimum capital amount mandated by the regulatory authority to ensure that firms are financially stable and solvent.||The net financial resources available at the disposal of a firm include- securities, plus equity and debt.|
|It simply represents a firm’s total value n terms of capital structure like retained earnings, equity, and debt.||It ensures that firms maintain enough buffers to help them absorb losses and protect against systemic risks.||It shows a firm’s overall financial strength affecting its borrowing capacity, capacity to attract investors and valuation.|
|For its calculation, one has to consider different risks like liquidity, credit, operational, and market risks.||It has its base on those approaches standardized and defined by regulatory authorities centered around operational risk, credit risk, and market risk.||It encompasses the market value of debt instruments, equity, plus other liabilities and assets of financial nature.|
|EC gets used in investment decision-making, internal risk management, capital allocation, and regulatory compliance.||It shows a firm’s overall financial strength affecting its borrowing capacity, capacity to attract investors and valuation.||It shows a firm’s overall financial strength affecting its borrowing capacity, capacity to attract investors and valuation.|
Economic Capital vs Cultural Capital
Let us use the table below to understand the differences between the two:
|Economic Capital||Cultural capital|
|It represents the amount of financial resources needed to withstand losses from uncertainties and risks within a firm.||Assets other than financial ones, like knowledge, education, social connections, cultural awareness and skills, contribute to a person’s success and status in society.|
|It has to be acquired and developed using upbringing, education, exposure to cultural activities, and social interactions.||Assets other than financial ones, like knowledge, education, social connections, cultural awareness, and skills, contribute to a person’s success and status in society.|
|For its calculation, one has to consider different risks like liquidity, credit, operational, and market risks.||Assets other than financial ones, like knowledge, education, social connections, cultural awareness, and skills, contribute to a person’s success and status in society.|
|It gets used in investment decision-making, internal risk management, capital allocation, and regulatory compliance.||Cultural capital gets measured using cultural prestige, social recognition, and symbolic value.|
|It directly influences cultural capital as it provides all the resources for its development.||It indirectly influences economic capital as it provides all the resources for its development.|
|EC widens access to financial stability, investment opportunities, and financial resources.||It widens access to professional opportunities, prestigious educational institutions, and exclusive social circles.|
Frequently Asked Questions (FAQs)
Economic capital can lead to cultural capital by:
a. Promoting cultural experiences
b. Granting access to quality education
c. Aiding in preferred consumption patterns
d. Helping make investments in cultural assets
e. Creating influential networks.
Rich people can provide cultural education, its financial resources facilitate cultural engagement on the whole, networking, investments, and the above factors combined contribute to the cultural development of society, individuals, and country.
In sociology, economic capital refers to non-financial assets such as education, knowledge, social connections, cultural awareness, and skills contributing to an individual’s success and social status.
In banking, economic capital refers to the amount of capital a bank needs to hold to cover potential losses from risks and uncertainties associated with its operations. In short, it measures a bank’s financial resilience and ability to absorb losses.
An economic capital framework refers to a collection of methodologies, models, and strategies businesses and financial institutions employ to evaluate and measure the capital necessary to endure potential risks and uncertainties. Thus its primary purpose lies in determining the suitable capital level required to sustain a company’s operations and effectively handle its risks.
This article has been a guide to what is Economic Capital. Here, we explain it with its examples, comparison with regulatory and cultural capital, and formula. You may also find some useful articles here –