What is Economic Capital?

Economic capital refers to the amount of money a company has to have to stay solvent and avoid bankruptcy. The concept is most important within financial industries and sectors, such as banks. However, it exists in any business structure or entity wherein risks or liabilities are taken on that a company may be called upon to pay for.

Generally, the definition of economic capital encompasses primarily liquid assets, which means it includes only money or monetary equivalents, such as bonds, that could easily be converted into cash when necessary. Difficult-to-sell assets may not be considered part of a company's economic capital, since the company might not be able to sell those assets if called upon to come up with the money to cover its debts or a risk.

Economic capital is closely related to the capital reserve a company has. Capital reserve essentially refers to the amount of money the business has in the bank, just in case. The difference is, however, that generally the required amount of economic capital is determined by the individual company, while laws may require a bank or financial institution to have a sufficient capital reserve to cover the deposits of a certain percentage of accounts held by the bank.

A company can determine the amount of capital it needs by considering the amount of risk it has assumed and by its expected losses as a result of the risk. When a company has taken on a risk, such as an investment in a potentially risky asset, it should have enough money to pay for the liabilities and costs it has occurred. The company's credit rating also factors in to how much capital it should have on hand, since the higher the rating, the less capital it may need. It should also have enough money that it will not go bankrupt if that risk does not pan out.

If a company has sufficient capital to cover those risks, then it is likely to receive a good credit rating or risk rating. If it does not have enough money and is low on capital, it may have a high risk rating or a low credit score and be deemed a poor investment. Companies, especially financial institutions, generally publish or make available data on the amount of capital they have to demonstrate their financial strength to the market.