Economic capital (EC) refers to the amount of risk capital that a bank estimates it will need in order to remain solvent at a given confidence level and time horizon. Regulatory capital (RC), on the other hand, reflects the amount of capital that a bank needs, given regulatory guidance and rules. This article will highlight how EC is measured, examine its relevance for banks, and compare economic and regulatory capital.

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Risk Management

Banks and financial institutions are faced with long-term future uncertainties that they intend to account for. It is in this context that the Basel Accords were created, aiming to enhance the risk management functions of banks and financial institutions. Basel II provides international directives on the regulatory minimum amount of capital that banks should hold against their risks, such as credit risk, market risk, operational risk, counterparty risk, pension risk, and others. Basel II also sets out regulatory guidance and rules for modeling regulatory capital and encourages firms to use EC models. EC as a concept and a risk measure is not a recent phenomenon but has rapidly become an important measure among banks and financial institutions.

Regulatory Capital

When banks calculate their RC requirement and eligible capital, they have to consider regulatory definitions, rules, and guidance. From a regulatory perspective, the minimum amount of capital is a part of a bank's eligible capital. Total eligible capital according to regulatory guidance under Basel II is provided by the following three tiers of capital:


Economic Capital



Relevance of Economic Capital


Performance Measure
A bank's management can use EC estimates to allocate capital across business streams, promoting those units that provide desirable profit per unit of risk. An example of performance measure that involves EC is a return on risk-adjusted capital (RORAC), risk-adjusted return on capital (RAROC) and economic value added (EVA). Figure 1 shows an example of a RORAC calculation and how it can be compared between the business units of a bank or financial institution.

Business Return and/or Profit EC Estimates RORAC

Figure 1: RORAC of two business units during one year


Comparing to RC
Another use of EC is to compare it with RC requirement. Figure 2 provides an example of some risks that can be assessed by an EC framework and how it could be compared to RC requirement.

Figure 2: RC requirement and EC estimate

Measuring EC


AIRB assumes that a loan portfolio is large and homogeneous, that longer-term assets are more risky, as reflected in the so-called maturity adjustment capped at five years, and that higher quality ratings have a higher correlation to reflect systemic risk. It also evaluates risk by rating classes and assumes a perfect correlation between rating classes and diversification within a rating class. (For more, see Measuring And Managing Investment Risk.)

Value-at-risk (VaR) models are typical EC frameworks for market, credit risk, and other risks. However, for credit risk, it is usually referred to as credit value-at-risk (CVaR). As an example, consider the loss distribution of a loan portfolio for relatively secure loans. The expected loss represents a loss that arises from the daily business, while the unexpected loss is the number of standard deviations away from the expected loss (the tail of the distribution). In the current example, suppose the unexpected loss is calibrated at the 99.95% confidence level, which corresponds to an 'AA' rating. Therefore, banks may calibrate their economic capital models according to management's risk appetite, which is usually in line with the bank's target rating. (For more, see An Introduction to Value at Risk.)


The Bottom Line

EC is a measure of a bank's risk capital. It is not a recent concept, but it has rapidly become an important measure among banks and financial institutions. EC provides a useful supplementary instrument to RC for business-based decisions. Banks are increasingly using EC frameworks and it will most likely continue to grow in the future. The relevant question might be whether EC could one day supersede RC requirements.