De leurs ennemis les sages apprennent bien des choses. (Aristophane)
The new regulations (Basel II and Solvency II) introduced a new kind of risk indicator: economic capital. To better understand this risk measure, we described the links between ALM and financial analysis. It is now time to explain in detail the main advantages of economic capital as risk measure.
There is not only one definition for economic capital but many: each definition corresponds to a specific system of reference.
Economic capital is different from accounting equity, i.e. the equity according to the IFRS. There is not only one capital but three different capital definitions according to the system of reference: the accounting, the regulatory or the shareholder system.
The regulators defend the interest of the depositors and of the global financial system. To do so, they tend to limit the risk exposures by imposing a minimum regulatory capital.
The rating agencies defend the interest of the debt holders, i.e. solvency. They compute company default probability as a risk measure on the economic value.
From a regulatory perspective, the ratio Cooke introduced:
Regulatory capital is computed from IFRS consolidated equity capital. Some treatments ...