Economic capital

What is Economic capital?
Economic capital represents the emerging best practice for measuring and reporting all kinds of risk across a financial organization. It is called "economic" capital because it measures risk in terms of economic realities rather than potentially misleading regulatory or accounting rules. It is called economic "capital" because part of the measurement process involves converting a risk distribution to the amount of capital that is required to support the risk, in line with the institutions target financial strength (eg. credit rating).
While some risk distributions can be calculated with more certainty than others - market risks tend to be more amenable than operating risks, for example - the approach can be applied in principle to almost all bank risks, and to any business line. Economic capital therefore provides management with a standardized unit, a dollar of economic capital, for comparing and discussing opportunities and threats. Economic capital numbers can also be multiplied by an institutions equity hurdle rate (the minimum acceptable rate of return on equity) to offer a cost of risk number that is comparable to other kinds of bank expense.
As such, economic capital offers an enterprise-wide language for discussing and pricing risk that is related directly to the principal concerns of management and other key stakeholders: institutional solvency and profitability.
As Warren Buffett has stated, one of the most important jobs of a CEO or CFO is capital allocation. Shareholders entrust management to invest their capital wisely, knowing exactly where it is invested, and what return they can expect on it. Management should also make sure that any capital generated by a business unit is reinvested wisely.
In manufacturing organizations, capital investment is easy to understand because it is largely required to finance plant and equipment. However, it is more difficult to understand where capital is invested in financial institutions, because capital is required to support risk.
Therefore, in order to understand where your shareholders capital is invested, you must understand the risks in your financial institution. This is the motivation behind Economic Capital linking risk to required capital.
A bank should undertake an assessment of capital adequacy at least once a year. Capital adequacy is determined by making a comparison between calculated Economic Capital and actual capital held by the institution.
Whether over or undercapitalized, firms can now take action as follows:
One of the most immediate benefits of measuring Economic Capital is the ability to measure return on equity (ROE) at any level within an organization business unit, products, customers, or even transactions. This is an important input into the strategic planning process identifying which activities to grow, shrink, or fix.
Although financial institutions have attempted to adopt an ROE discipline through the use of such approaches as Economic Value Added (EVA), they are missing one of the most important issues understanding how much equity is required for each activity. Economic Capital provides a sound theoretical basis for attributing Economic Capital to all activities.
Comprehensive risk measurement: the model should address the full range of risks faced by the institution, including all credit, interest rate, market, and operational risks and should utilize stress tests of key parameters that would affect the size of exposures or degree of risk, e.g., for subprime lending: delinquency rates, recovery rates, attrition rates, and utilization rates.
Objective and statistically sound linkage of risk to capital: an example of this would be a statistically measured maximum probability of becoming insolvent in conjunction with a target public agency debt rating.

Debenture vs Stock Vs Bond

A debenture is an unsecured loan you offer to a company. The company does not give any collateral for the debenture, but pays a higher rate of interest to its creditors. In case of bankruptcy or financial difficulties, the debenture holders are paid later than bondholders. Debentures are different from stocks and bonds, although all three are types of investment. Below are descriptions of the different types of investment options for small investors and entrepreneurs. Debentures and Shares When you buy shares, you become one of the owners of the company. Your fortunes rise and fall with that of the company. If the stocks of the company soar in value, your investment pays off high dividends, but if the shares decrease in value, the investments are low paying. The higher the risk you take, the higher the rewards you get. Debentures are more secure than shares, in the sense that you are guaranteed payments with high interest rates. The company pays you interest on the money you lend it until the maturity period, after which, whatever you invested in the company is paid back to you. The interest is the profit you make from debentures. While shares are for those who like to take risks for the sake of high returns, debentures are for people who want a safe and secure income.

Financial Risk

Financial risk is normally any risk associated with any form of financing. Risk is probability of unfavorable condition; in financial sector it is the probability of actual return being less than expected return. There will be uncertainty in every business; the level of uncertainty present is called risk.

Depending on the nature of the investment, the type of 'investment' risk will vary. High risk investments have greater potential rewards, but also have greater potential consequences.

A common concern with any investment is that the initial amount invested may be lost (also known as "the capital"). This risk is therefore often referred to as capital risk.

If the invested assets are being held in another currency, there is a risk that currency movements alone may affect the value. This is referred to as currency risk.

Many forms of investment may not be readily salable on the open market (e.g. commercial property) or the market has a small capacity and may therefore take time to sell. Assets that are easily sold are termed liquid: therefore this type of risk is termed liquidity risk.

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both). The default events include a delay in repayments, restructuring of borrower repayments, and bankruptcy.

Counter party risk, otherwise known as default risk, is the risk that an organization does not pay out on a credit derivative, credit default swap, credit insurance contract, or other trade or transaction when it is supposed to.

Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices. The associated market risk are:

Equity risk, the risk that stock prices and/or the implied volatility will change.

Interest rate risk, the risk that interest rates and/or the implied volatility will change.

Currency risk, the risk that foreign exchange rates and/or the implied volatility will change.

Commodity risk, the risk that commodity prices (e.g. corn, copper, crude oil) and/or implied volatility will change.

Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates. It also includes other categories such as fraud risks, legal risks, physical or environmental risks.

Counterparty credit risk consists of both presettlement and settlement risk. Presettlement risk is the risk of loss due to the counterparty’s failure to perform on an obligation during the life of the transaction. This includes default on a loan or bond or failure to make the required payment on a derivative transaction. Presettlement risk can exist over long periods, often years, starting from the time it is contracted until settlement.

In contrast, Settlement Risk is due to the exchange of cash flows and is of a much shorter-term nature. This risk arises as soon as an institution makes the required payment until the offsetting payment is received. This risk is greatest when payments occur in different time zones, especially for foreign exchange transactions where notionals are exchanged in different currencies. Failure to perform on settlement can be caused by counterparty default, liquidity constraints, or operational problems.

Most of the time, settlement failure due to operational problems leads to minor economic losses, such as additional interest payments. In some cases, however, the loss can be quite large, extending to the full amount of the transferred payment. An example of major settlement risk is the 1974 failure of Herstatt Bank. The day it went bankrupt, it had received payments from a number of counterparties but defaulted before payments were made on the other legs of the transactions.