Risk Capital and More Lessons from the Titanic

In last week's blog post, I summarized an illustration I use to explain the differences between Regulatory, Equity, and Risk (economic) Capital, equating each type of capital to the lifeboat capacity of the RMS Titanic in 1912.  

The ship was built to hold 64 large lifeboats carrying a total of over 4,000 people--more than enough as the ship itself could only house a maximum of 3,547 passengers and crew.

More than required...

Moreover, the British Board of Trade (the regulators) required that a ship of Titanic's size had to carry 16 lifeboats for 990 people.  Management (White Star Line) met the 16 lifeboat requirement and then some...the larger lifeboats aboard the Titanic could hold 70+ people each for a total of 1,178 ("equity capital").

...but less than necessary

Although equity capital exceeded regulatory capital in this case, "risk capital" fell short of the 2,224 passengers and crew on board.  As equity capital held should be equal to at least risk capital, would 32 lifeboats have saved all 2,224 aboard?**

Economic Capital Before the Financial Crisis

We see the problem for a naval disaster that occurred over 100 years ago.  What about the latest financial disaster from 2007-09?  If economic capital was truly in play pre-2007 crisis, why was there a crisis?

Economic Capital is the best estimate of required capital that banks use to manage their own risk; it is an internal measure, based on a bank's estimate of its own appetite for risk.  The conclusion, therefore, is that economic capital failed, not because it is a useless measure but because banks' conclusions about risk matched those of the White Star Line:  Risk of sinking is quite low when you are aboard the "Unsinkable."  



* Details from Wikipedia, see RMS Titanic article.
**Probably not.  Even though the lifeboats could have held 1,178, only 32% (710) of the passengers and crew survived.  That's a study in operational risk that I'll get to in a later post.