Economic capital is a measure of the financial strength of a company’s balance sheet. It is a calculation of how much capital, or liquid assets a business has, based on the likelihood of possible losses it may experience due to various risks associated with their operations. Economic capital represents the amount of financial resources available for the business to absorb losses.

Risk management is an integral part of financial services and economic capital plays a crucial part. It helps to identify, assess and monitor the risks that the business faces and provides an indication of the financial capacity of the business to absorb potential losses. Economic capital provides a measure of the capacity of the business to absorb losses due to the specific risks it faces. By assessing the potential losses associated with each of these risks, the company can determine how much capital, or financial resources it needs to set aside as a buffer against these various risks.

Traditional capital allocation techniques still apply for economic capital, such as capital asset pricing models (CAPM), which relates returns and risks of different asset classes by calculating the appropriate required rate of return for each asset based upon its specific risk characteristics. Economic capital models combine the process of risk assessment and capital budgeting in order to establish the most accurate and cost effective capital allocation among the various risks.

Companies use economic capital to ensure that they maintain the appropriate level of capital reserves. This is done in order to manage risk more effectively, as well as to calculate returns on equity and insurance requirements. Such calculations sometimes require the use of Value at Risk (VaR) models, where risk is expressed in terms of an probability of loss.

Economic capital is a continuously evolving concept. Companies must continuously evaluate their risk environment, capital adequacy and business strategy, to ensure that the right level of capital is available and those resources are being used in the most effective way. It is also necessary to review existing practices and the ongoing process of setting economic capital.

Overall, economic capital is essential to financial services companies, as well it could be used to measure the risk associated with holding assets, funding activities and setting up protective buffers against losses. It is also used to help companies make better capital budgeting decisions and protect their balance sheets.