Economic capital ideas

This month sees the start of Charles Smithson's fourth series of Class Notes, which will run in alternate issues of Risk through the remainder of this year and into 2008. Class Notes is an educational series, designed to pull together the threads of recent developments and thinking about key issues in risk management and derivatives dealing. In this inaugural article, Smithson explains the concept behind economic capital

Economic capital is a measure of the amount of equity capital an enterprise needs to support a risk. More specifically, it is the amount of equity capital necessary to cover losses arising from that risk to some confidence level.

1. For example, many of the large international banks define economic capital as the amount of equity capital needed to cover losses 99.97% of the time.

In contrast with an accounting view, where capital could be viewed on the right-hand side of the balance sheet