Economic capital is the amount of capital that a company needs to survive any risks that it takes. It’s essentially a way of measuring risk. Financial services companies calculate economic capital internally. Economic capital should not be confused with regulatory capital (also known as a capital requirement).
What is regulatory capital in banking?
The total regulatory capital is equal to the sum of Tier 1 and Tier 2 capital. Tier 2 capital includes revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves. Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital.
What is economic capital or risk capital?
Economic Capital: Economic capital is the amount of capital that a bank needs to run the business and remain solvent. Also called the risk capital, it is defined as a capital required to absorb the impact of unexpected losses during a time horizon at a certain level of confidence.
Is capital money an economy?
Economic capital is the estimated amount of money needed to cover possible losses from unexpected risk. A firm’s economic capital number can also be seen as a measurement of solvency.
Why do banks need regulatory capital?
Capital is a key ingredient for safe and sound banks and here is why. Banks take on risks and may suffer losses if the risks materialise. To stay safe and protect people’s deposits, banks have to be able to absorb such losses and keep going in good times and bad. That’s what bank capital is used for.
Why is regulatory capital important?
Bank capital performs several very important functions. It absorbs losses, promotes public confidence, helps restrict excessive asset growth, and provides protection to depositors and the deposit insurance fund.
Which is higher economic capital or regulatory capital?
Our analysis also shows that the relative position of economic and regulatory capital is mainly determined by the cost of bank capital: economic capital is higher (lower) than regulatory capital when the cost of capital is low (high).
What is the difference between economic and risk capital?
Economic Capital: Economic capital is the amount of capital that a bank needs to run the business and remain solvent. Also called the risk capital, it is defined as a capital required to absorb the impact of unexpected losses during a time horizon at a certain level of confidence. This is calculated by banks themselves using their own risk models.
What does regulatory capital mean in the FRM?
Regulatory capital in the FRM refers to Basel. As you suggest, regulatory capital is externally mandated. Economic capital, as you suggest, is internal.
How is book Capital different from economic capital?
This acts as a buffer in place of economic capital. Book Capital: This is the actual capital that the bank has, which is primarily the equity capital, but can also include other debt. Most banks, in practice, maintain their book capital above the calculated economic capital or stated regulatory capital, in order to be safe.
