Regulatory capital enforces minimum capital requirement in banks. We normally calculate capital adequacy ratio or risk-based capital for the purpose. Economic capital is used by financial institutions to support decisions about what business lines or transactions to pursue. Economic capital can be defined as one consisting of owners equity, retained earnings and sub-ordinated debt. One can assign economic capital charges to business lines or transactions. The purpose is to identify business lines or transactions that would indicate optimal use of limited economic capital. In this article, we have determined a process for determination of economic capital for steel sector financed by banks. Once the economic capital is known for a particular sector, banks can ascertain how higher or lower is the economic capital of a particular sector in relation to the regulatory capital. This will also indicate whether the capital is justified in relation to the risk taken by the bank.

We have collected data from a bank indicating exposure of individual obligors in the steel sector. As the data collected were supposed to be confidential, we have indexed the same.Credit risk is defined as the losses of the borrower to repay his obligations or the deterioration of the borrower’s credit quality in the event of a default. This simple definition hides a couple of underlying risks. Virtually, the “quantity” of risk is the outstanding balance loaned to the borrower and the“quality” of risk reflects both the chances that the default occurs and the reduction of loss from the guarantees in the event of default. The amount of risk represented by the outstanding balance at the date of default may differ from the ultimate loss in the event of default because of potential recoveries. Recoveries would depend upon any credit risk mitigators, such as guarantees, either collateral or third party guarantees, the capabilities of negotiating with the borrower and the funds available, if any, to repay the debt after repayment of other lenders who may have a priority claim over the borrowers’ assets/funds either by virtue of legal rights, superior bargaining position, efficient debt collection strategies, etc.