# Economic Capital (EC)

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## What is Economic Capital (EC)?

Economic capital (EC) is a risk factor usually employed by financial services businesses and institutions. It measures the amount of capital a company needs to operate effectively and remain solvent in the face of operational risk.

## Key Takeaways

• Economic capital is a useful tool for risk management of financial firms.
• You can calculate EC using a basic formula or a more extensive formula that takes into account different types of risk.
• EC is useful for measuring business performance, risk-adjusted returns, pricing, and more.
• The data for calculating EC can be difficult to obtain and may require sophisticated and costly modeling.
• EC requires the assumption of various risk factors, which, if incorrect, can skew the end calculations.

## Economic Capital Formula

There are various ways to calculate the economic capital formula.

The most simple formula is:

Economic Capital = Value at Risk (VaR) − Expected Loss

Where:

• Value at Risk (VaR): The worst-case financial scenario for a company within a given probability.
• Expected loss: The average loss a firm expects to incur based on historical calculations and various scenarios.

However, using the economic capital definition, firms can examine their risk factors more closely and utilize a more in-depth calculation that accounts for various types of risk:

Economic Capital =√(VaR Credit Risk2 +VaR Market Risk2 +VaR Operational Risk2 +⋯) − Expected Loss

This more detailed formula accounts for credit risk, market risk, operational risk, and other types of risk as necessary.

## Understanding Economic Capital

Economic capital is a useful tool for financial institutions to make more informed business decisions that either cause the institution to scale back risk or pursue more risky but potentially profitable business ventures.

As you can see in the chart below, an institution’s economic capital is represented by a range within which a firm believes its losses will be in the future. As previously explained in the economic formula definition, a firm’s expected loss is what it generally anticipates losing from its normal business operations.

Meanwhile, the confidence level is the added risk of additional losses over a given time period. The EC is the difference between the expected loss and confidence level and measures any unexpected losses within the parameters.

## Economic Capital Uses

Regulatory compliance
EC is useful for credit rating agencies and internal compliance departments to measure risk exposure for stakeholders.

Risk management
EC can help quantify risk and the capital required to cover that risk. It can also help financial firms understand their various risk factors and profiles.

Performance
EC can help measure profitability on investments relative to their risk, along with evaluating the performance of various business segments.
Capital allocation
If a firm wants to allocate capital more effectively, it can use EC to ensure deployed capital is generating the highest risk-adjusted returns.
Produce development
EC is useful for the development of new financial products and services that balance risk and return.
Shareholder value
EC can help optimize value creation for shareholders, and inform dividend policies so that a company maintains enough capital to cover its risks.
Investment decisions
Before conducting a merger, EC can help evaluate a potential new investment to ensure it does not risk a firm’s financial well-being.

## Economic Capital vs. Regulatory Capital & Financial Capital

Economic CapitalRegulatory CapitalFinancial Capital

What is it? Capital to cover operational risks

What’s it used for? Ensure a company can manage risk and continue operating

Factors for calculation: Internal models and risk assessment

Uses: Internal risk management and decision-making

Example: Value-at-Risk (VaR)

What is it? Capital levels required by regulators

What’s it used for? Ensure stability and the prevention of insolvency

Factors for calculation: Regulatory framework and guidelines

Uses: Regulatory compliance and financial stability

Example: Minimum capital requirements

What is it? Total capital available, including debt and equity

What’s it used for? A holistic view of a company’s financial situation

Factors for calculation: Financial statements and accounting practices

Uses: Measure financial health and growth

Example: Shareholder equity

## Example of Economic Capital

Let’s look at a bank which has the following risks:

• Credit risk: Losses due to borrower default.
• Market risk: Losses from changes in market prices or interest rates.
• Operational risk: Losses from inefficiencies and failures in internal processes.

The bank estimates its potential losses from each risk as follows:

• Credit risk: \$100 million
• Market risk: \$80 million
• Operational risk: \$30 million

Meanwhile, its expected loss is \$50 million.

We can calculate the bank’s EC (in millions) using the formula:

EC = √(1002+802+302) − 50

EC = \$81.57 million

This means the bank needs to hold \$81.57 million in capital to absorb various unexpected losses in its business. If the bank holds less than this amount, it may be at risk for insolvency, but if it holds substantially more capital, it can look to deploy its excess reserves into additional business ventures.

## Economic Capital Pros and Cons

Pros

• Helps financial institutions with risk management
• Allows institutions to allocate capital more efficiently and make more informed decisions
• Shows a company how much capital it needs to prepare for potentially adverse future events
• Helps show shareholders and regulators the financial health of a company

Cons

• Requires sophisticated quantitative modeling, which can be costly to implement and maintain
• Greatly depends on assumptions for its model, which, if inaccurate, will generate figures that are not useful
• Requires a firm to obtain large amounts of data, which can be time-consuming and difficult to complete
• It is a complex financial tool that may be difficult to convey to stakeholders

## The Bottom Line

Understanding the economic capital meaning can be a useful way for financial institutions to manage their risk and make more informed business decisions.

However, this complex financial model isn’t easy to calculate and requires making many assumptions about potential risks that are difficult to quantify. Still, economic capital is one tool that financial firms can use to help their businesses maintain solvency and grow on a risk-adjusted basis.

## FAQs

### What is the formula for economic capital?

#### Related Terms

##### Daniel Pelberg
Financial Journalist
##### Daniel Pelberg
Financial Journalist

Dan has been a content and copywriter in the financial services and fintech industries for over a decade where he has seen firsthand the evolution of financial services and helped many companies convey complex information to a wide audience, both in the B2B and B2C markets. Dan has an affinity for all types of content in the financial sector, whether it’s writing an educational script for a new financial product video, a monthly newsletter for a financial advising firm, or a blog post for a new Bitcoin service. As a digital freelancer, Dan has had the opportunity to work with…