On price risk and economic capital

Economic capital is defined as the level of capital required to support risk-taking activity, in order to maintain solvency and ensure continuity of operations. Commonly, economic capital is a realistic measure of the contingencies the institution could face from market, credit, operational and legal risks. It serves to absorb unexpected losses at a given degree of statistical confidence. And it is usually applied in companies that are part of the financial system/capital market.

Economic capital should not be confused with regulatory capital, whose sole purpose is to ensure the existence of critical capital in the system. It is a quasi-static measure focused on the present, while the former is a dynamic, forward-looking measure that incorporates expectations.

Determining economic capital is a strategic decision that affects the risk/return relationship across business lines. And, therefore, it allows institutions to measure risks continuously and accurately, allocating monetary resources efficiently to cover the economic effects of the activities they carry out. It has two forms of use: 1) at the business line level and 2) at the integrated level (Enterprise). In case 1, it is used to manage the credit portfolio, risk-based pricing of assets, customer profitability analysis and, lately, to set management incentives. At the integrated level, it is used to evaluate business performance, prepare capital usage budgets and strategic planning, analyze acquisitions and sales of assets, and determine the adequacy of corporate capital levels.

Economic capital and risks – conclusions

Based on the above, we can conclude that managing economic capital is a key element in running successful companies. The model will be only as good as our ability to identify, measure and budget the inherent risks of the business. Because in the financial market it will be essential to measure credit, operational and market risks in order to estimate potential contingencies and define the adequate capital buffer . Regulated players must always keep in mind that regulation in the financial sphere is inherently reactive, so they must go considerably beyond what their respective regulations indicate in managing capital.

“Regulated players must always keep in mind that regulation in the financial sphere is inherently reactive. They must therefore go considerably beyond what their respective regulations indicate in managing capital.”

Given the growing importance of income from the securities market, a good starting point might be to ask, “given what level of decline and volatility in the value of my investment portfolio, will economic capital remain positive?”. A prudent approach would use the answer to that question to build the risk appetite framework, set the limits, and from that point define the corresponding strategic planning according to the risk-adjusted profitability desired. Setting goals without being clear about what we can risk, and how we will respond to changes in the market (plan B), is very fragile preparation. Dear reader and investor, what level of losses are you willing to tolerate?

Author: Stefan Bolta
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