Confidence crunch

Many financial institutions calibrate their required level of economic capital by considering the probability of default associated with a target debt rating. However, as the financial crisis has shown, confidence in a bank can erode before its Tier I capital ratio reaches the established minimum level. Tony Rich argues banks need to move beyond solvency-based measures of economic capital in the internal capital adequacy assessment process

The term ‘economic capital’ describes the collection of practices used to measure the economic effects of risk-taking activities that give rise to losses. One of the central challenges in translating this simple conceptual definition into a practical measure of risk is to determine exactly how much uncertainty the bank should be able to absorb. It is clearly not possible to cover every single