What are the differences between the economic definition of capital and the book value definition of capital?

The book value definition of capital is the value of assets minus liabilities as found on the balance sheet.  This amount often is referred to as accounting net worth.  The economic definition of capital is the difference between the market value of assets and the market value of liabilities.

1. How does economic value accounting recognize the adverse effects of credit and interest rate risk?

The loss in value caused by credit risk and interest rate risk is borne first by the equity holders, and then by the liability holders.  In market value accounting, the adjustments to equity value are made simultaneously as the losses due to these risk elements occur.  Thus economic insolvency may be revealed before accounting value insolvency occurs.

1. How does book value accounting recognize the adverse effects of credit and interest rate risk?

Because book value accounting recognizes the value of assets and liabilities at the time they were placed on the books or incurred by the firm, losses are not recognized until the assets are sold or regulatory requirements force the firm to make balance sheet accounting adjustments.  In the case of credit risk, these adjustments usually occur after all attempts to collect or restructure the loans have occurred. In the case of interest rate risk, the change in interest rates will not affect the recognized accounting value of the assets or the liabilities.