Background on Economic Capital
Volatility and Capital: Measures of Risk
Conceptual Framework for Economic Capital Models and Required Inputs
Recovery Risk and Economic Capital
The Significance of Economic Capital to Financial Institutions
Economic Capital for Retail Credit Card Portfolios
Economic Capital for Counterparty Credit Risk
Economic Capital for Securitisations
Economic Capital for Market Risk
Measuring and Calculating Economic Operational Risk Capital
A Fundamental Look at Economic Capital and Risk-Based Profitability Measures
A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules
Allocating Portfolio Economic Capital to Sub-Portfolios
Spectral Capital Allocation
Evaluating Design Choices in Economic Capital Modelling: A Loss Function Approach
Economic capital (EC) and risk-based profitability measures such as risk-adjusted return on capital (RAROC) and economic profit (EP) are widely used throughout the finance industry. As their definitions have evolved over time, they – in our view – appear to lack a formal foundation and, at times, guidance for their application.
In this chapter, we take a step back to look at EC requirements and profitability measures from a slightly more rigid perspective – elaborating on procedures to determine justifiable capital requirements as well as linking their measures to modern portfolio theory.
The chapter is structured as follows:
the next section discusses if and how the right amount of EC for a bank can be determined.
the following section, we present a formal description of the calculation of EC with some focus on its allocation.
the penultimate section deals with the integration of EC into popular risk-based profitability measures.
finally, in the last section, we derive an alternative risk-based profitability measure based on the capital asset pricing model (CAPM) and study how it ties in with profitability measures currently used.
A summary of our main result