Economic Capital. MarketCheese

Economic capital (also known as ECap, E-cap, and EC) is the estimated amount of money a company needs to ensure survival in case something goes off the planned script. Economic capital is usually estimated by a company itself and requires utilizing the company's own proprietary models. The expected outcome of this analysis is the amount of money that is necessary to cover any occurred risks.

Economic capital shouldn’t be confused with regulatory capital, which is the amount of money a company must have since it's required by the company's financial regulator.

Procedure of Economic Capital

Every financial organization needs economic capital as a measure that helps to predict and determine the organization’s operational risks. Also, an organization should report its risks to a financial organization. This kind of measure doesn’t use regulatory rules and accounting much, it prefers to use economic realities, making an accession on a realistic basis. This happens because judgments based only on rules and accounting may be confusing and inaccurate. Thus, economic capital is regarded as a view that may convey a more realistic description of a company’s solvency.

The assessment procedure for economic capital is quite clear. To estimate economic capital a company needs to convert some amount of supposed risk to the amount of money that is needed to cover it. The calculation includes the company's financial strength (which is the ability of a company to generate revenue and have sufficient cash flow) or credit rating and expected losses (which is expenses of the business, usually are covered by operating profits).

Economic Capital based measures

If a company is in search of how to determine the right directions to follow, the best way is to calculate economic capital and define risk/reward ratios. There are also performance measures that involve economic capital:

return on risk-adjusted capital (RORAC);
risk-adjusted return on capital (RAROC);
economic value added (EVA).

Companies that use such measures are in general more successful, they may get more capital to make the most effective risk management. Also, for similar purposes Value-at-risk (VaR) is utilized.