The concept of economic capital (also referred to as "risk capital" or "risk-based capital") is increasingly being adopted by banks and other financial institutions as a standard by which to determine the amount of capital needed to protect against financial distress in the event of unexpectedly large losses.
When calculating portfolio economic capital requirements, most models estimate critical values corresponding to extreme tail percentiles of a portfolio or whole-bank loss distribution. Economic capital requirements are then set to cover a measure of "unexpected loss," defined as the difference between the estimated mean of the loss distribution and the estimated loss level corresponding to the chosen critical tail percentile.
The pecking order theory of capital structure (Myers (1984), Myers and Majluf (1984)) hypothesizes that the primary determinant of firms' financing decisions is the problem of information asymmetry about firm quality between firm insiders and outsiders. Aware of their informational disadvantage, external investors demand a lemons premium (Akerlof (1970)) that raises the required rate of return on external capital relative to its full- information level. Faced with this problem, firm managers acting in the interests of existing shareholders follow a pecking order of financing choices.
Economies frequently pursue policies that lead to fiscal crises, usually typified by sustained deficits that eventually lead to an inability to increase or roll-over debt (without paying an historically abnormal premium), and an associated sharp increase in tax rates and decline in government expenditure. The recent experience of Greece, Ireland, and Portugal, are only the latest examples of such crises. See Reinhart and Rogoff (2009) for many more examples from the historical record. Policies that run up debt, and eventually encounter borrowing constraints, may be the rational response of citizens (and their politicians) who face a world interest rate that is below their subjective rate of time preference.
