BIS speaks out on economic capital calculation

BASEL – New findings and recommendations for the calculation of economic capital have been released by the Basel-based Bank for International Settlements (BIS) – the force behind the Basel II regulatory capital requirements accord. The paper, Range of practices and issues in economic capital modelling, covers the use of economic capital, risk management and aggregation, internal governance and the validation of economic capital models.

Economic capital is calculated across a bank’s business units and according to different risk types, as a measure of unexpected losses attributable to the firm’s risk exposure. This differs in definition from regulatory capital requirements, although the alignment of Basel II’s risk-based capital requirements with firms’ day-to-day risk management practices – especially through aspects such as the ‘use test’ – is designed to bring economic and regulatory capital calculations closer together.

Klaas Knot, chairman of the Basel Committee's risk management and modelling group and director of supervision policy for the Netherlands Bank, says: “The paper presents the current state of practices in economic capital modelling. It discusses the steps banks have taken to address the modelling challenges they face and reviews supervisory concerns relating to current bank practices.

“I believe the paper provides an important contribution to our understanding of economic capital modelling within large banking organisations. In addition, it sets out a number of recommendations that should help strengthen both banking and supervisory practices.”

The BIS accepts comments on the recommendations until November 28, 2008, and the paper may be downloaded from the following link.

http://www.bis.org/publ/bcbs143.pdf?noframes=1