Introduction

In the realm of credit risk assessment, understanding the differences between economic capital and regulatory capital is essential for banks and financial institutions. Economic capital and regulatory capital are two distinct measures that serve different purposes in risk management. This chapter aims to clarify the nuances between these two capital measures and provide insights into how economic capital is derived.

Economic Capital Vs Regulatory Capital

Economic capital and regulatory capital are not interchangeable terms; they serve distinct roles in measuring financial institution risk. Regulatory capital refers to the minimum capital requirement mandated by regulatory authorities to ensure the safety and soundness of financial institutions. It acts as a buffer against potential losses. Economic capital, on the other hand, is the capital necessary to absorb unexpected losses at a specific level of confidence. Unlike regulatory capital, economic capital reflects the actual risk exposure of a financial institution.

Derivation of Economic Capital

Economic capital is derived from the consideration of the inherent risks in a financial institution’s activities. This involves a comprehensive assessment of various risks, including credit risk, market risk, and operational risk. The economic capital calculation takes into account the probability of adverse events and their potential impact on the institution’s financial health.

The formula for calculating economic capital involves two components: unexpected loss (UL) and confidence level (CL): $$\text{Economic Capital} = UL \times \frac{1}{(1-CL)}$$

Example: Consider a bank that wishes to calculate its economic capital to absorb unexpected credit losses. The bank’s model estimates the unexpected loss at $$ 10$ million with a desired confidence level of $99 \%$. Plugging these values into the economic capital formula:

$$\text{Economic Capital}= \text{USD 10 million} \times \frac{1}{(1-0.99)}= \text{USD 1000 million} $$

Benefits of Economic Capital

Economic capital provides a more accurate representation of a financial institution’s risk exposure than regulatory capital. It considers the institution’s specific risk profile, risk appetite, and business activities. This precision enables institutions to allocate capital more efficiently, make informed risk management decisions, and align capital allocation with their risk tolerance.