Economic Capital

Introduction

In the summer of 2006, bankers and financial engineers lived in a rose garden. Financial markets were booming, risk premiums were low, financial engineers and their models were in high demand, and regulators had adopted Basel II regulations, which many bankers expected would allow them to reduce their capital requirements and grow their business further. Two years later, the garden had changed into a wasteland with credit losses mounting on the products developed by the same financial engineers, and spreading like wildfire to other areas of the financial markets. As a result, a number of banks (nearly) failed, the two largest mortgage providers in the United States and the largest insurer in the world were de facto nationalized, ...