Allocating Portfolio Economic Capital to Sub-Portfolios

Dirk Tasche

From an economic point of view, the risks that arise in a bank’s portfolio need to be covered by a corresponding amount of capital to absorb potential losses. This capital commonly is referred to as economic capital. It mainly represents the value of the company’s stock capital and comprises all reserves the bank is holding to cover occurring losses.11Depending on accounting standards, the economic capital may differ distinctively from the stock capital. For instance, in some European countries, hidden reserves play a crucial role in the definition of economic capital. See eg, Theiler (2004). In Matten (see 1996, p. 9), the role of capital is described as acting “as a buffer against future, unidentified, even relatively improbable losses, while still leaving the bank able to operate at the same level of capacity”.

In a situation of intensifying competition and decreasing return margins banks need to ensure an efficient use of their economic capital. It is becoming a core objective of risk management to ensure that the economic capital is invested efficiently in business lines yielding highest risk-adjusted performance. As a fundamental competitive necessity risk managers need to

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