Capitals (Economics)

In finance, mainly for financial services firms, economic capital is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, legal risk, and operational risk.

What is 'Economic Capital'?

Economic capital is the amount of capital that a firm, usually in financial services, needs to ensure that the company stays solvent. Economic capital is calculated internally and is the amount of capital the firm should have to support any risks it takes on.

The measurement process involves converting a given risk to the amount of capital that is required to support it. The calculations are based on the institution's financial strength (e.g., credit rating) and expected losses.

Financial strength is represented by the probability of the firm not becoming insolvent over the measurement period and is the confidence level in the statistical calculation. Most banks will use a confidence measurement of between 99.96% and 99.98%, which is the insolvency rate expected for an institution with a AA or Aa credit rating.

The firm's expected loss is the anticipated average loss over the measurement period. Expected losses represent the cost of doing business and are usually absorbed by operating profits.

The relationship between frequency of loss, amount of loss, expected loss, financial strength and economic capital can be seen in the following graph:

BREAKING DOWN 'Economic Capital'

Economic capital is used for measuring and reporting market and operational risks across a financial organization. Economic capital measures risk using economic realities rather than accounting and regulatory rules, which have been known to be misleading. As a result, it is thought to give a more realistic representation of a firm's solvency.

The Five Capitals

There are five types of sustainable capital from where we derive the goods and services we need to improve the quality of our lives.

Natural Capital is any stock or flow of energy and material that produces goods and services. It includes:

(a)Resources - renewable and non-renewable materials

(b) Sinks - that absorb, neutralise or recycle wastes

(c) Processes - such as climate regulation

Natural capital is the basis not only of production but of life itself!

Human Capital consists of people's health, knowledge, skills and motivation. All these things are needed for productive work.

Enhancing human capital through education and training is central to a flourishing economy.

Social Capital concerns the institutions that help us maintain and develop human capital in partnership with others; e.g. families, communities, businesses, trade unions, schools, and voluntary organisations.

Manufactured Capital comprises material goods or fixed assets which contribute to the production process rather than being the output itself – e.g. tools, machines and buildings.

Financial Capital plays an important role in our economy, enabling the other types of Capital to be owned and traded. But unlike the other types, it has no real value itself but is representative of natural, human, social or manufactured capital; e.g. shares, bonds or banknotes.

We are facing a sustainability crisis because we're consuming our stocks of natural, human and social capital faster than they are being produced. Unless we control the rate of this consumption, we can't sustain these vital stocks in the long-term. 
We believe that by maintaining and trying to increase stocks of these capital assets, we can live off the income without reducing the capital itself. But for this to happen, it is the responsibility of every organisation, business or otherwise, to manage these capital assets sustainably.
Sustainable development is the best way to manage these capital assets in the long-term. It is a dynamic process through which organisations can begin to achieve a balance between their environmental, social and economic activities.