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Economic capital

Thread starter #1
Hi David,

What exactly is economic capital?
My understanding is the economic capital is what is present in your balance sheet. This may be more or less than your regulatory capital.. Am I correct.

Thanks,
Kavita
 

brian.field

Well-Known Member
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#2
It is more of a Part II concept. Still, it has many definitions. It can be thought of as the amount of buffer capital that I company must have in order to achieve its target rating. It can be thought of as the amount of capital a company needs to protect itself against "unexpected" losses. The Range of Practices paper going into it a great deal. It also mentions that EC is measures "risk" and not dollars in a buffer, which I find to be somewhat confusing.

It is certainly separate and distinct from regulatory capital since it is an internal capital level, meaning the companies can make their own determination of the appropriate economic capital level (to a certain degree) where regulatory capital levels are entirely exogenous to the company.

Lastly, it is often the case that economic capital levels are actually higher than regulatory capital levels. When the regulatory capital level is above the economic capital level, the difference is called "stranded capital" and it is an interesting concept phenomenon since it means that the company cannot efficiently use this stranded capital for optimal use.
 
#4
David,


I am a little bit confused as to what are the differences between the Internal Capital Adequacy Assessment Process (ICAAP- Pillar 2) capital and Economic Capital (if any). Can you please provide some explanation on that?

Thank you,

Nick
 

brian.field

Well-Known Member
Subscriber
#5
ICAAP would externally prescribed, by definition, right? Which, in my eyes, would place it in the realm of "regulatory" capital rather than Economic Capital. EC is strictly defined within the company and not externally to the company.
 
#6
Brian,

Pillar II of Basel requires from banks to provide their own estimates of required capital ( Internal Capital Adequacy Assessment Process) which sounds a lot like EC.
 

brian.field

Well-Known Member
Subscriber
#7
Brian,

Pillar II of Basel requires from banks to provide their own estimates of required capital ( Internal Capital Adequacy Assessment Process) which sounds a lot like EC.
I am not an expert with ICAAP but your characterization seems (to me) to be slightly inconsistent with my understanding of pillar 2 (supervisory review). As an example, under the standardized approach (credit), a supervisor can require certain inputs for LGD, PD, or EAD. These may differ from and are distinct from the company's own assertions.
 
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