Economic Capital Modeling

Capital management has probably never been more important than it is today. Worldwide the financial industries are facing problems of capital shortages due to new regulations and volatility in the markets. Generally, management uses two types of capital to make their decisions of capital allocation:

Regulatory Capital:

It is the amount of capital required by regulation. For example, Basel II’s pillar I establishes minimum capital requirement which is the sum of the capital required for Credit, Market and Operational Risk. Under Pillar II, financial institutions are required to keep the capital for other material risks. We support our clients to estimate the regulatory capital required for all types of risks.

Economic Capital:

It is the capital available to the banks to absorb losses to stay solvent. According to Bank for International Settlements - Economic capital can be defined as the methods or practices that allow banks to attribute capital to cover the economic effects of risk-taking activities.

Effective capital allocation suffers a major setback due to the management complexities in banks due to use of both Regulatory capital and Economic capital. One of the most challenging part while using Economic capital is to use it to glean insights from it like right size of capital buffer, concentration risk etc.

We help our clients in increasing their capital efficiency by aligning Economic Capital and Regulatory Capital for decision making. Our Capital Allocation model not only takes care of defaults, but also takes care of the more likely and relevant events such as the risk of failing to maintain regulatory ratios. Our model goes into more granularity to decide the capital needs of the firm, so that it not only captures risk indicators but also risk mitigating factors.

We estimate economic capital for each risk category for bank to compare the economic capital required vis-a-vis regulatory capital to enhance the capital efficiency.

We establish correlations between different risk categories based on stressed scenarios of the past and use these correlations to aggregate the economic capital requirement at the institution level for a specified confidence interval.