Evolution of Economic Capital Measurement and Management

Bogie Ozdemir

This chapter is dedicated to a discussion of economic capital, and begins with the evolution of economic capital measurement and management in banks. Although EC has been an established risk metric in banks with known benefits, its usage is being marginalised as an unintended consequence of Basel III. Later in the chapter, we will demonstrate a methodology to estimate EC for defaulted loans that is important in the post-crisis era, with many banks holding large impaired credit portfolios. We then turn our attention to insurance companies, where EC is a much newer and a more complicated concept, and examine what EC represents in the presence of policyholders. We will then discuss how EC can be estimated for market risk (in comparison to banks): the one-year VaR approach versus the run-off approach. We will also explore how to quantify the potential benefits from hedging. Finally, we consider the use of EC in pricing, followed by a look at EC-based profitability estimation.

ECONOMIC CAPITAL IN BANKS

EC methodologies have been long-established and well-documented for banks. Our main focus in this chapter is on the evolution of EC as a risk and capital management measure. We will

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