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Economic Capital

The economic capital gives the company the ability to absorb potential losses so that it can continue operate during difficulties.

What is Economic Capital?

The amount of liquid capital required to cover known losses is called economic capital. A company’s economic capital 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 economic capital. As a result, economic capital gives a more realistic representation of a firm’s solvency.

Example

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 economic capital (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 capital to weather bad times. One way of building the buffer is to calculate and hold economic prosperity.

Owais Siddiqui
1 min read
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