Economic Capital

[Monirul Islam]

The concept of economic capital was initially developed as a tool for internal risk management. Economic capital answers the following question: "How much financial capital does the business need to cover potential future loss based on current risk exposure?"

Most companies use specific formulas for estimating their economic capital. The way to consider risks and the method of quantifying possible losses has changed over time. Some risks are easy, such as credit risk on a loan, where the exact amount of possible loss is stated in a promissory note and can be adjusted for inflation. Operational risks are more challenging; opportunity costs are even more difficult.

Once a company believes it has an effective model of calculating economic capital, future business decisions can be strategically made to optimize the risk/reward trade-off. However, this is easier said than done. Validating a model through backtesting only highlights its possible accuracy but can never completely prove it. There is also no guarantee that future conditions will mirror past conditions; significant deviations in variable relationships can render an otherwise well-built model as unsatisfactory.

Source: Investopedia