In finance, mainly for financial services firms, economic capital is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, and operational risk. It is the amount of money which is needed to secure survival in a worst case scenario. Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital.

Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as value at risk.

The first accounts of economic capital date back to the ancient Phoenicians, who took rudimentary tallies of frequency and severity of illnesses among rural farmers to gain an intuition of expected losses in productivity. These calculations were advanced by correlations to predictions of climate change, political outbreak, and birth rate change.

The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the organization.

[ See also

• Asset allocation
• Basel I
• Basel II
• Capital structure
• Financial risk management
• Financial services conglomerate
• RAROC, risk-adjusted return on capital
• Solvency II

[ References

• Porteous, Bruce; Pradip Tapadar (2005). Economic Capital and Financial Risk Management for Financial Services Firms and Conglomerates. Palgrave Macmillan. ISBN 1-4039-3608-0. 

• Porteous, Bruce and Tapadar, Pradip (2008) "The Impact of Capital Structure on Economic Capital and Risk Adjusted Performance, ASTIN Bulletin, 38, 341 - 380"
• Porteous, Bruce and Tapadar, Pradip (2008) "Asset Allocation to Optimise Life Insurance Annuity Firm Economic Capital and Risk Adjusted Performance, Annals of Actuarial Science, 3, 187 - 214"

[ External links

• FDIC.gov, Economic Capital and thee Assessment of Capital Adequacy Federal Deposit Insurance Corporation
• BIS.org, "Basel Committee, Bank for International Settlements"

• CEIOPS"