Economic capital, which can be defined as the methods or practices that allow financial institutions to attribute capital to cover the economic effects of risk-taking activities, has increasingly become an accepted input into decision-making at various levels within banking organisations. Despite the advances that have been made by banks in developing their economic capital models, the further use and recognition of risk measures derived from these models remain subject to significant methodological, implementation and business challenges.
This paper provides an overview of the range of practices in economic capital modelling at large banking organisations and, based on this review, discusses a range of issues and challenges surrounding economic capital models. The paper also discusses practices implemented by banks that attempt to address these challenges and reviews supervisory concerns relating to the current state of practice.
As economic capital has - to varying degrees - become a component of many banks' internal capital adequacy assessment processes (ICAAP), this paper is addressed to banks that have implemented or are considering implementing economic capital into their internal processes. The paper is also addressed to supervisors, who are required under Pillar 2 (supervisory review process) of the Basel II Framework, to review and evaluate banks' internal capital adequacy assessments.