Abstract
This chapter highlights the purpose of risk capital, and discusses the way in which risk capital can be attributed to business lines as part of a risk-adjusted performance measurement system. It is only by forging a connection among risk measurement, risk capital, and performance measurement that firms can ensure that the decisions taken by them reflect the interests of stakeholders—such as bondholders and shareholders. Risk capital is the cushion that provides protection against the various risks inherent in a corporation's business so that the firm can maintain its financial integrity and remain a going concern even in the event of a near-catastrophic worst-case scenario. Risk capital provides essential confidence to the stakeholders of the business such as suppliers, clients, and lenders (for an industrial firm), or claim-holders such as depositors and counterparties in financial transactions (for a financial institution). In banking, risk capital is also often called “economic capital,” and in most instances, the generally accepted convention is that risk capital and economic capital are identical. Risk capital measurement is based on the same concepts as the value-at-risk (VaR) calculation methodology. Risk capital numbers are often derived from the sophisticated internal VaR models.
Published Version
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