Economic capital: A brief history and practical applications today

Abstract

Learning from trends on capital levels leading into the Great Recession of 2008, this paper presents three approaches for mining the benefits of economic capital today to inform strategic planning and help with capital management. The paper recognises the benefits of economic capital over the standardised regulatory risk weight method. Economic capital’s distribution-oriented measures better discriminate risk across assets over plausible worst-case scenarios; however, this paper surmises that economic capital models contributed to financial institutions having less capital than needed to weather the Great Recession. It explains how correlation treatment and understating ‘tail’ risk in those models may have understated capital needs in severe stress conditions. Using historical performance data, the paper illustrates the impact of losing diversification benefits. It also quantifies tail risk for four business lines common to US financial institutions. The paper concludes with methods for recognising when economic capital approaches need to be adjusted to avoid understating unexpected loss in some cases and overstating unexpected loss in others. It offers solutions for avoiding both types of errors, including leveraging off the infrastructure built up by US financial institutions in response to stress testing requirements. The paper provides templates for readers to build on for their own capital planning framework.