What is Economic Capital?
The amount of liquid capital required to cover known losses is called economic capital. A company’s viable asset is the amount of money it needs to survive whatever risks it takes. It’s simply a risk assessment tool. Internally, financial services firms calculate viable assets. As a result, EC gives a more realistic representation of a firm’s solvency.
One way of estimating Economic Capital is through Value at Risk (VaR) estimation. Suppose the entity’s one-day VaR is \$2.5 million, and it has \$2.5 million in liquid reserves. In that case, it has enough viable assets(i.e., it is unlikely to go bankrupt in a one-day projected tail risk event).
Why is economic capital necessary?
As an essential risk management tool, it is recommended that organisations have enough assets to weather bad times. One way of building the buffer is to calculate and hold commercial prosperity.