Economic Capital and Financial Risk Management

The latest global financial crisis has highlighted the need for financial services firms to adopt comprehensive risk management techniques to identify, manage and mitigate risks promptly and efficiently. To this end, a key risk management tool is to hold sufficient capital to back the risks a business is running. In recent times, financial services regulators have also initiated a move towards risk-based economic capital approach with different regulations for banks (Basel 2 and 3) and insurance firms (Solvency 2). In this paper, a generic definition of economic capital is proposed using a stochastic approach, which is then used to quantify economic capital for a capital repayment mortgage, a lifetime mortgage, a life insurance annuity and a conglomerate operating a range of financial services. The paper highlights economic capital as a risk management tool that unifies capital calculation techniques across all financial services firms and conglomerates, irrespective of their line of operation.