June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 18 of 92 3. ECONOMIC CAPITAL ADEQUACY One of the fundamental aspects in economic capital adequacy is the determination of available equity. It is the equity of a company that will be assessed against the risk capital requirements to determine if a company is adequately capitalized in light of the risks that it faces. The fundamental question that needs to be answered is “Do I have sufficient equity to withstand the risks that my company faces?” A company faces a myriad of risks and as management executes the business plan to grow shareholder equity, they must also be aware of the threats to that equity that could reduce or potentially wipe out the shareholder’s investment. In determining the Risk Capital Requirement within the Capital Adequacy Framework, it is important to understand the concept of ‘Equity-at-Risk.’ The level of equity a company possesses provides assurances to many stakeholders, primarily debt holders, that there is sufficient equity in the company to withstand Operative, Credit, Market, and Business risk events and remain a going concern. In the following Chapters, the Risk Capital requirement is framed in terms of potential unexpected losses due to risk events in the Market, Credit, Operative and Business risk categories. The reason for this is that losses erode the equity component and reduce the ability of the company to service is capital requirements, including its debt. Therefore, when assessing the Risk Capital Requirement we are concerned with potential losses that will erode equity, and not necessarily concerned with earnings shortfalls or potential variability of the net present value (NPV) of future earnings. While shortfalls to earnings expectations will have an impact on the growth of equity, and will be viewed as a negative event by shareholders, those shortfalls will not necessarily degrade the capital structure unless the shortfall results in negative earnings. Also, using a NPV value entails aggregating all future potential earnings into one distribution that includes all time periods. By using this approach, discreet time periods when a company’s equity is eroding may not be revealed. Each of these aspects will be discussed within this chapter in greater detail. Figure 3.1 graphically displays the framework for Economic Capital Adequacy determination.