How is "economic capital" defined?

Economic capital is defined as the amount of capital that a financial institution needs to hold in order to cover potential losses that may arise from its business activities over a specified period. This concept is critical in risk management as it quantifies the risks faced by the institution and helps ensure that the institution remains solvent even during adverse conditions. By using economic capital, organizations are better equipped to absorb unexpected losses and can align their risk-taking activities with their overall business strategy.

This approach provides a holistic view of risk by considering various types of risk exposures, such as credit risk, market risk, operational risk, and others, allowing for more informed decision-making and resource allocation. It differs from merely looking at cash reserves or the value of assets, as it emphasizes the adequacy of capital in relation to the potential risks involved in business operations.