Economic capital refers to the amount of capital that an institution needs to hold in order to cover potential losses resulting from various risk-taking activities. This capital is not just the regulatory capital required by authorities but also includes additional funds based on the institution's internal risk assessment. Economic capital helps institutions to understand and manage their exposure to risks effectively. Option C best defines economic capital as it emphasizes the practices of assessing risk and allocating capital accordingly.

A is incorrect. Economic capital is a measure of the institution's capacity to absorb losses, not the actual amount invested in risky ventures.

B is incorrect. While it is true that economic capital involves setting aside funds to absorb losses from risk, it is not limited to losses resulting from credit risk alone.

D is incorrect. Economic capital takes into account both known and potential risks and is not limited to uncertainties in the future.

Things to Remember

• Regulatory capital vs. economic capital
• Factors influencing economic capital calculation
• Importance of stress testing in determining economic capital
• Relationship between economic capital and risk appetite
• Integration of economic capital into overall risk management framework