Economic Capital

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Economic capital is the amount of capital an organisation, such as a bank or insurer, estimates it needs to cover unexpected losses from all its risks, at a chosen level of confidence, based on its own internal risk models.

Losses can be divided into expected losses, which are anticipated and covered by pricing and provisions, and unexpected losses, which arise from bad outcomes. Economic capital is the buffer held against unexpected losses.

Organisations calculate economic capital by modelling their credit, market, operational, insurance and other risks, usually at a high confidence level consistent with their target credit rating. For example, a bank aiming for a strong rating might hold enough economic capital to survive losses that would occur only once in a thousand years or more on average.

Economic capital is used internally to understand risk, set limits, measure risk-adjusted performance and allocate capital between business lines. For example, a bank may compare the profit of each division with the economic capital it uses, to judge which activities earn adequate returns for their risk.

Economic capital differs from regulatory capital, which is the minimum amount required by regulators using prescribed rules. The two can differ significantly, because internal models may reflect an organisation's specific risks and diversification more precisely.

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