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.
Related or Semi-related Video
Finance: What is the Uniform Net Capital...17 Views
Finance a la shmoop what is the uniform net capital rule alright well it's
basically a speed limit rule for a securities brokerage in that there is a [Speed limit sign with 'uniform net capital rule' on it]
uniform ie same across the board minimum amount of equity or capital that you [Definition of uniform capital rule]
must keep on hand at all times if you're the brokerage well the rule revolves
around the storied belief that there will always be rainy days maybe even [Trees being blown in the wind]
days that demanda you know bearded guy with pairs of animals and a boat and
that the brokerage has to be stable and sturdy enough to withstand the wrath of [Brokerage written on the side of Noah's ark]
you know Oprah or whoever's running the world specifically this rule states that [Oprah giving a speech]
even though your investment firms actual worth is constantly wildly fluctuating [Stock chart of Shmidelity]
due to making trades for your clients and quote holding unquote stocks and
assets for them you've got to have enough liquid cold hard cash to meet
your obligations at the end of the business day you can't be speculating on [The uniform net capital rule broken down into each part]
the markets yourself as a broker dealer and you have to have a net of debt and
or investments minimum amount of capital in 1975 this rule was enacted to give
the SEC the power it needed to make sure that these firms didn't become you know [Guy speaking in front of a trading floor]
accidental Ponzi schemes which would have destroyed the faith and Trust and [Definition of a Ponzi scheme]
the integrity and the American investment community and that would be
really bad well each security held by the broker dealer is valued by the SEC
factoring in what they call a haircut which is different for each security [Stocks, bonds and cash each with different hair styles]
well the haircut for each is determined by the current market price and how
liquid the investment actually is that is if the brokerage needed to quickly
get out of five million shares could they well like if the average trading
days total volume is only two million shares like some small cap tech stock
well then yeah that would be a big problem if they had to suddenly sell
five million shares then that huge onslaught of supply onto the market [Dumpster truck dumps stock]
would likely crash the stock ten twenty thirty forty percent something like that
so the SEC applies that liquidity haircut or discount to the calculations
of what they consider to be true net capital like it's not like you're trying
to sell five million shares of Google which you could do in
minutes right very little haircut there on google so as you can guess every [Someone selling 5 million shares of Google online]
security is completely different when figuring out how much of it is actually
usable by a broker dealer in the net capital rule if everything you know hits
the fan tomorrow be careful though the uniform net capital rule still does not [Stock chart showing a big decline in value]
protect against ponzi schemes yeah different the only kind of scheme there [Picture of 'The Fonz']
you ask your parents remember happy day oh come on