Economic Capital

Key takeaways
* Economic capital is the amount of capital a firm needs to remain solvent given its specific risk profile.
* It is calculated internally—often with proprietary models—and reflects economic realities rather than regulatory formulas.
* Economic capital converts a loss distribution into a capital requirement by combining expected losses and a chosen confidence level.
* It is used to allocate capital across business lines and to drive performance metrics such as RORAC, RAROC, and EVA.

What is economic capital?

Economic capital quantifies the capital a financial firm should hold to cover unexpected losses over a specified horizon with a chosen degree of confidence. Unlike regulatory capital, which is set by external rules, economic capital is an internal measure designed to reflect the firm’s true exposure to market, credit, and operational risks.

How economic capital is measured

Measurement translates the statistical distribution of potential losses into a dollar amount of capital. Two components are central:

• Expected loss: the average loss over the measurement period (the “cost of doing business”), typically absorbed by operating profit.
• Unexpected loss: the tail of the loss distribution beyond expected loss, determined by a confidence level (financial strength or probability of non-insolvency).

A simple relationship often used is:
Economic capital = Loss at chosen confidence level − Expected loss

Common approaches include value-at-risk (VaR) and other tail-risk measures. Firms use internal models that reflect their portfolio mix, correlations, and business-specific risk drivers.

Confidence level and financial strength

The confidence level (for example, 99.9% or 99.96%) represents the probability the firm will remain solvent over the chosen horizon. A higher confidence level requires more economic capital to cover more extreme, low-probability losses.

Uses and performance metrics

Economic capital serves several purposes:
* Capital allocation: directing capital to business lines with the best risk/reward profile.
* Performance measurement: calculating risk-adjusted returns and economic profit using metrics such as:
* RORAC (Return on Risk-Adjusted Capital)
* RAROC (Risk-Adjusted Return on Capital)
* EVA (Economic Value Added)
* Risk management: setting limits, pricing, and strategic decisions informed by modeled exposures.

Practical example

A bank evaluates its loan portfolio over a one-year horizon and chooses a 99.96% confidence level. The model indicates that losses at that confidence level exceed expected losses by $1 billion. That $1 billion represents the economic capital required to absorb extreme losses beyond normal expectations. If the bank lacks this capital, possible responses include raising capital, tightening underwriting standards, or reallocating exposure among portfolio segments that offer a better risk/reward trade-off.

Managing and acting on economic capital

Firms translate economic capital estimates into actionable steps:
* Adjust underwriting, pricing, or limits to reduce required capital.
* Reallocate capital to business lines with higher risk-adjusted returns.
* Raise capital or change the balance sheet composition to maintain a target rating or confidence level.
* Integrate economic capital into stress testing and contingency planning.

Bottom line

Economic capital is an internally derived, risk-based measure of how much capital a firm needs to remain solvent under adverse but plausible scenarios. By incorporating expected losses, tail-risk confidence levels, and firm-specific modeling, it offers a realistic foundation for capital allocation, performance measurement, and strategic risk management beyond what regulatory metrics provide.