Defining and measuring business risk in an economic‐capital framework

Abstract

Purpose The objectives of this paper are to: define business risk; identify whether economic capital could be used to mitigate this risk; and investigate business‐risk measurement methodologies. Design/methodology/approach The paper analyzes definitions used in theory and practice and derived a definition. It analyzes three measurement methodologies: analogue companies/peer group analysis, statistical methods, and scenario analysis. These methodologies are tested against the criteria of effective management control, because economic capital is increasingly used as a management control instrument. Findings Economic capital can be used as business‐risk mitigant albeit not the only one. The measurement methodology of scenario analysis satisfies most of the criteria for effective control. Practical implications This paper opens a discussion to further develop the scenario approach in theory and practice. Originality/value Despite the amount of economic capital that financial institutions hold to cover business risk, it has received little attention in literature. This paper opens a discussion on a relatively new field of research.