Economic Capital
Risk Capital Framework
Expected losses are budgeted and covered as expenses in the usual course of business. On the other hand, economic Capital is defined as the amount of capital needed to cover unexpected losses during extreme events. That is why, it is measured as the potential unexpected losses over a one year time period at a 99.97% confidence level.
Risk Capital is a consistent and comprehensive risk management tool. It is based on assessment of risk parameters: PD, EAD, LGD. Risk capital designed to reflect the amount of capital needed to cover unexpected economic losses during extreme events. It has migrated to finer segmentation in conjunction with Basel II initiative, leverages Vasicek (Basel II) distribution assumptions and benefits from large sample sizes in retail portfolios.
Economic Capital covers not only market, operational and credit risk but should also cover insurance risk, pension risk and any other risk identified. For practical reasons the economic capital used within the bank only includes market, operational and credit risk. Economic Capital as used in determining our capital requirements takes diversification into consideration. Economic Capital is different from Pillar 1 capital requirements calculated under the advanced methodology because the calculation is based on the different risks, different confidence levels and takes diversification factors into consideration.
Economic Capital Formulae:
Economic capital calculation for credit risk may be based on a regulatory capital formulae with the following changes:
- 99.9% regulatory confidence level may be stratified to 99.97%;
- Correlation parameter R is estimated by the bank;
- Capital requirement may get diversification benefit/internal choice;
- Diversification taken into account when calculating Economic Capital accounts for: diversification across product lines and diversification across risk types;