Economic Capital

Economic capital is the amount of capital a bank thinks it needs to manage the risk it’s taken on. This is not to confuse “economic capital” with “regulatory capital,” which is the amount of capital banks are required to have on hand—based on the law—to make sure the bank can remain solvent. Think: Run on the banks. Investors pull their money. Banks are restricted from lending more than, say, 25x the capital they have as their own equity in the bank itself.

Economic capital is like when you plan a budget for yourself, whereas regulatory capital is like...what your parents say you should be making ($$$-wise) and what you should be doing with it (if you have helicopter parents, anyway).

In the same way, economic capital is a lot more realistic than regulatory capital. When you make a budget for yourself—and when a financial services firm is calculating its economic capital—you take into account things that are relevant to you, and not necessarily relevant to everyone else. For instance, different banks have different types of clients, which affects their risk profile, which affects their economic capital calculations. Regulatory capital—like your parents judging you—isn’t aware of these little details, and doesn’t take them into account in the calculations. It’s more of a general, big picture, “this-is-how-it-should-be” kind of thing.

If you were wondering...yeah, banks are probably annoyed at regulatory capital just like you are at your parents for judging your spending choices. They just don’t understand.