Economic and regulatory capital

Capital charges are especially problematic.

Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. Economic Capital EC is a measure of risk expressed in terms of capital. Because capital charges are based at least in theory on the riskiness of a business line or transaction.

The first firm-wide implementation of ROC at all levels of a firm was a system Bankers Trust implemented during the s.

Ex-post, it is actual loss. Tier 2 supplementary capital: Accordingly, when ROC is used for internal decision making, the ROC of a business line or transaction is typically calculated as an average ROC over several years or the life of the transaction.

While the international standards of bank capital were established in the Basel I accord, Basel II makes significant alterations to the interpretation, if not the calculation, of the capital requirement.

This article will highlight how EC is measured, examine its relevance for banks and compare economic and regulatory capital.

Credit risk and market risk are fundamentally different—like comparing apples and oranges. Although Tier 1 capital has traditionally been emphasized, in the Lates recession regulators and investors began to focus on tangible common equitywhich is different from Tier 1 capital in that it excludes preferred equity.

While ROE is defined firm-wide, it is not defined for individual transactions or business lines. This is capital allocation. Regulatory capital equals the sum of capital charges, perhaps with offsets to reflect hedging or other mitigating factors.

A business line or transaction might be expected to lose money in its first year only to become profitable in subsequent years. These techniques originated with return-on-asset calculations, as described below. Department heads take a keen interest in how capital charges are to be assessed.

Economic Capital

Firms seek to hold capital in excess of economic capital. RAROC was well publicized, and during the s, a number of other banks developed their own firm-wide systems. Additionally, the capital tiers differ in their ability to absorb losses; Tier 1 capital has the best abilities to absorb losses.

Also, income earned on that economic capital may be added to revenue: In financemainly for financial services firms, economic capital is the amount of risk capitalassessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concernsuch as market riskcredit risklegal riskand operational risk.

Value-at-risk VaR and similar measures are also based on economic capital and are used by financial institutions for risk management.

The main international effort to establish rules around capital requirements has been the Basel Accordspublished by the Basel Committee on Banking Supervision housed at the Bank for International Settlements.

Capital requirement

Tier 1 capital[ edit ] Main article: In June this framework was replaced by a significantly more complex capital adequacy framework commonly known as Basel II. So far, since economic capital is rather a bank-specific or internal measure of available capital, there is no common domestic or global definition of EC.

Inthe Committee decided to introduce a capital measurement system commonly referred to as Basel I. 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.

Economic capital

Summed capital charges, less offsets, is economic capital. If the bank had a shortfall in economic capital, it could take measures such as raising capital or increasing the underwriting standards for its loan portfolio in order to maintain its desired credit rating.

Therefore, economic capital is often calculated as value at risk. Basel II also sets out regulatory guidance and rules for modeling regulatory capital and encourages firms to use EC models.

Using Economic Capital To Determine Risk

The relationship between frequency of loss, amount of loss, expected loss, financial strength, and economic capital can be seen in the following graph: The capital is presumably invested somewhere, and ROC should reflect any extra income from that investment.

Specifically, the bank wants to discern the Economic and regulatory capital of economic capital needed to absorb a loss approaching the 0. Most banks use a confidence measurement of between The risk-based capital guidelines are supplemented by a leverage ratio requirement.

It also provides an instrument for comparing requirement and economic capital (where exists), capital or solvency level perceive to be required to maintain a specific external rating assigned by credit rating agencies, levels set by peers and comparable competitors, shareholders’ influence, etc.

Economic capital is capital a financial institution or other trading organization determines—based on its own risk analyses—is an appropriate buffer against possible losses from a transaction, a business line or its operations overall.

Economic capital is calculated and utilized in ways similar to those of regulatory capital under the Basel. On October 12,staff of the Federal banking agencies hosted a national banker teleconference to discuss the Proposed Simplifications to the Capital Rule Pursuant to the Economic Growth and Regulatory Paperwork Reduction Act of Incorporating both regulatory capital and economic capital into a unified decision measure allows organizations to better optimize risk/return profiles, facilitate strategic planning and limit setting and define risk appetite.

Unlike other measures of capital, Economic Capital (EC) captures the combined effect of the various risks and interactions thereof to which an insurer is exposed.

A capital requirement (also known as regulatory capital or capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets.

Economic and regulatory capital
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