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Asset and Liability Management: The Banker’s Guide to Value Creation and Risk Control, Second Edition by Youssef F. Bissada, Jean Dermine

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Economic capital allocation

The allocation of economic capital is based on the observation that the equity of any company is a buffer whose role is to absorb eventual losses to avoid bankruptcy. Indeed, losses reduce retained earnings and the equity base. When equity is depleted, there is a risk of default.

So, if you consider the curve in Figure 7.1 that describes the probability distribution of the income on a loan, the risk for e-Bank is related to losses on the loan, the downside risk on the left side of the curve. Equity is needed to cover the downside risk. In theory, one would need a large amount of equity to cover all possible shortfalls. As this would be too expensive, banks use a pragmatic approach whereby the equity allocated must ...

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