Economic Capital

Economic capital is a capital-based way to express risk. For instance, the amount of capital required to maintain financial stability at a certain degree of confidence and time horizon could be a concern for a bank. In contrast to Regulatory Capital required measurements, EC may be thought of as the amount of risk capital from the standpoint of the banks. Economic capital is primarily intended to support business choices, whereas regulatory capital (RC) is meant to establish minimum capital needs against all risks in a bank, following various regulatory laws and guidelines.

There is currently no standard definition of economic capital domestically or internationally because it is more of a bank-specific or internal measure of available capital. Additionally, there are a few components that many banks share when defining economic capital. Grade 1, Grade 2, Grade 3, or classifications used by rating agencies and other forms of capital, such as expected earnings, unrealised profit, or an implied government guarantee, may all encompass EC projections.

Economic Capital

Economic Capital vs Regulatory Capital

• EC is particularly significant since it may give critical answers to specific business choices or for analysing a bank's various business segments. It also serves as a tool for comparing RC.

• The management of a bank can utilise EC estimations to distribute capital across business streams, favouring those that yield a desirable profit per unit of risk. Return on risk-adjusted capital (RORAC), risk-adjusted return on capital (RAROC), and economic value added are examples of performance measurements that use EC (EVA).

Economic Risk Capital

Economic capital is a capital-based measure of risk. More specifically, it is the amount of capital required by a corporation (typically in the financial services industry) to be solvent given its risk profile.

Internally, the corporation calculates economic capital, sometimes using proprietary methods. The resulting figure is also the amount of capital that the firm should have to sustain any risks that it takes.

• The long-term future uncertainties that banks and other financial institutions must take into account. The Basel Accords were developed in this context to enhance the risk management capabilities of significant financial institutions. Basel, I, Basel II, and Basel III are the three sets of laws that make up the agreements, which are guidelines for the banking sector.

• Basel II offers worldwide guidelines on the required minimum capital that banks must keep to protect themselves against risks including counterparty risk, credit risk, market risk, operational risk, and pension risk, among others. In addition, Basel II outlines regulatory guidelines and requirements for modelling regulatory capital and encourages companies to utilise economic capital models. Although the idea of EC and its use as a risk indicator are not new, banks and other financial institutions are quickly adopting it as a crucial metric.
  
  

Economic Risk Capital

Economic Capital Framework

The term "economic capital framework" refers to the risk capital required by the central bank while accounting for various hazards. The economic capital framework reflects the capital that an institution needs or must keep as a hedge against future risks, occurrences, or losses.

India's Economic Capital Structure

• Section 47 of the RBI Act specifies that the RBI's profits are to be remitted to the government after making allowances "often given by bankers."

• In 2013-14, the RBI established a Technical Committee chaired by Y. H. Malegam to assess the RBI's internal reserves level and sufficiency, as well as its surplus distribution strategy.

• The RBI implemented a draught Economic Capital Framework in 2015 in response to the above committee's recommendations.

• Risks to the balance sheet and contingent risks were both attempted to be covered.

Why Does it Require Fixing?

1. The existing economic capital framework, which governs the RBI's capital requirements and terms for transferring its surplus to the government, is based on the central bank's conservative risk assessment, and a review of the framework would result in excess capital being released, which the RBI could then share with the government.

2. The government thinks that the RBI has far more reserves than is required to weather any financial problems that India may confront.

3. Some central banks throughout the world (such as the United States and the United Kingdom) hold 13% to 14% of their assets as reserves, compared to the RBI's 27% and some (such as Russia) keep even more.

4. Economists have previously advocated for the RBI to release "excess" capital that the government can put to productive use. In 2013, the Malegam Committee estimated the excess to be Rs 1.49 lakh crore.
   
   

Economic Capital Framework

How Does Economic Capital Operate?

In the corporate sector, there are three primary categories of economic capital:

• Debt

• Equity

• Specialty

Each form of funding source is unique, yet they may all support business expansion.

Conclusion

A bank's risk capital is quantified by its EC. Although it is not a brand-new idea, banks and other financial organisations are quickly adopting it as a crucial step. For business-based choices, EC offers a beneficial complement to RC. Banks' use of EC frameworks is growing, and it is expected to do so in the future. The pertinent query could be whether the need for regulatory capital might ever be replaced by economic capital.