Economic capital represents the emerging best practice for measuring and
reporting all kinds of risk across a financial organization. It is called
"economic" capital because it measures risk in terms of economic realities
rather than potentially misleading regulatory or accounting rules. It is
called economic "capital" because part of the measurement process involves
converting a risk distribution to the amount of capital that is required to
support the risk, in line with the institutions target financial strength
(eg. credit rating).
While some risk distributions can be calculated with more certainty than
others - market risks tend to be more amenable than operating risks, for
example - the approach can be applied in principle to almost all bank risks,
and to any business line. Economic capital therefore provides management
with a standardized unit, a dollar of economic capital, for comparing and
discussing opportunities and threats. Economic capital numbers can also be
multiplied by an institutions equity hurdle rate (the minimum acceptable
rate of return on equity) to offer a cost of risk number that is
comparable to other kinds of bank expense.
As such, economic capital offers an enterprise-wide language for discussing
and pricing risk that is related directly to the principal concerns of
management and other key stakeholders: institutional solvency and
profitability.
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