Capital vs. Capital vs. Capital

When Economic (Risk) Capital was the talk of the financial services industry, I included a simplified explanation of it in my risk management course at the American Bankers Association's Stonier Graduate School of Banking. Subsequently, I wrote an article on it, entitled Risk capital and lessons from the Titanic, when I was with the Risk Research and Quantitative Solutions group at SAS Institute.  Thankfully, even after my departure from that organization, the article still lives in cyberspace, though my byline has been removed (and rightly so).  In summary:

• Equity Capital - the amount of operational capital (cash) that the management of a financial institution deems necessary to operate its business.
• Regulatory Capital - the amount of equity capital required of a financial institution by its regulator.
• Economic, or Risk, Capital - an estimate of the worst possible decline in the financial institution’s amount of capital at a specified confidence level, within a chosen time horizon, saving for a "rainy day."  It gives senior management insight into a worst-case scenario.

Ideally, financial institutions should hold equity capital of an amount equal to risk capital.  Setting capital aside, so to speak, for a very bad day.

In my course and in the SAS article, I equate three different types of capital to the lifeboat capacity on White Star Line's Best-in-Class (for 1912) luxury passenger ship, the RMS Titanic.  

Capital illustrated:

• The regulatory body for passenger ships in early 20th Century England was the Board of Trade.  It required that 10,000+ ton vessels such as the Titanic carry only 16 lifeboats with a capacity to hold 990 people.  In this case,
• "Regulatory Capital" = 990 
• The management of White Star Line made the decision to carry 16 lifeboats able to hold 1,178 people, more than what was required by the Board of Trade.  
• "Equity Capital" = 1,178  
• Risk capital, given the worst-case scenario:
• "Risk Capital" = 1316 passengers + 908 crew = 2,224

Uh oh.