Economic Capital Foundations

Ahraz Sheikh

3.1 INTRODUCTION

The aim of this chapter is to describe the general features of economic capital models. These are used as the foundation for all risk types (within scope) throughout this book. Chapter 1 introduces the concept of economic capital, which, alongside regulatory capital and stress testing, ensures bank survival under various economic and financial conditions, whether good, normal or distressed.

While Pillar 1 sets the minimum regulatory capital requirements for core risks (ie, market, credit, counterparty credit and operational risk) using specified methodologies, its coverage is not entirely comprehensive. Regulatory capital considers capital requirements for a one-year period (or meaningful equivalent) to cover a range of potential loss outcomes for given quantile levels. However, such regulatory formulas are calibrated against the requirements of peer banks through data collection exercises. Thus, they may not represent the bank’s true capital needs.

Pillar 2 augments this by capturing any shortcomings of Pillar 1 estimation, as well as any additional risks that the bank may be exposed to. While the regulators may specify additional formulas for some