Economic Capital and Economic Profit

Nordea has calculated internal capital requirements using the Economic Capital (EC) framework since 2001.  In comparison to Basel I regulatory capital, EC is a more sophisticated measure of the capital required to cover long-term losses. The Basel II Accord closes the gap between regulatory capital and EC, after which calculations will be conducted using similar risk-based models.

Nordea calculates EC for the following risk types: credit risk, market risk, operational risk, business risk and life insurance risk.
 
Quantitative models are used to estimate the unexpected losses for each of the risk types compiled into EC:

Risk types in Economic Capital

Credit risk is calculated using a set of capital factors. The capital factors are developed for different products, customer segments and credit quality categories. The factors have been estimated using a portfolio model, where probability of default, loss given default and exposure at default are inputs, and are reviewed and updated annually. The parameter estimation framework used for EC will to a large extent also be used in the upcoming Basel II framework.

Market risk for the banking business is based on scenario simulation and Value-at-Risk (VaR) models tailor-made for EC. For the Life insurance business an asset and liability management (ALM) – model is used, which is based on scenarios generated by Monte-Carlo simulation. The market risk in Nordea’s internal defined benefit plans is based on VaR models.

Operational risk reflects the risk of direct or indirect loss, or damaged reputation resulting from inadequate or failed internal processes. It is calculated according to the standardised approach within Basel II.

Business risk represents the earnings volatility inherent in all businesses due to the uncertainty of revenues and costs due to changes in the economic and competitive environment. The main risk drivers are reputation risk, strategic risk, liquidity risk and indirect effects of structural interest income risk. Business risk is calculated based on the observed volatility in historical profit and loss time series that is attributed to business risk.

Life insurance risk represents risk in the actuarial assumptions for mortality and morbidity used to price life insurance products.  It is calculated as percentages of the EU minimum solvency requirement (death and disability risk) and technical provisions (longevity risk).

Measurement period

In order to achieve consistent risk measurement throughout Nordea, the measurement period is set to one year and the confidence level is 99.97% for all risk types. Nordea's total EC equals the amount needed to cover unexpected losses during one year in 99.97% of all possible cases.

When all types of risk of the Group are combined, considerable diversification effects will arise, since it is highly improbable that all unexpected losses occur at the same time. However, highly correlated risk types reduce the achievable level of diversification. Credit risk and market risk are both highly correlated with the development of the general economy and thus reduce the level of diversification. Still, the diversification effects mean that the total EC is lower than the sum of the EC for each risk type.