economic and regulatory capital

Financial and Regulating Capital in

Banking: What is the Difference? ∗

Abel Elizalde

Rafael Repullo



Come july 1st 2006


We analyze the determinants of regulating capital (the minimum essential by regulation), economic capital (that chosen by investors without regulation), and genuine capital (that chosen with regulation) in the single risk factor model of Basel II. We present that factors that only affect economic capital, such as the intermediation margin and the cost of capital, can are the cause of large deviations from regulating capital. Real capital is closer to regulatory capital, however the threat of closing undercapitalized banks produces significant capital buffers. Marketplace discipline, proxied by the coverage of deposit insurance, raises economic and actual capital, although the effects are tiny. Keywords: Basel II, bank regulation, capital requirements, industry discipline, put in insurance, fast corrective action, credit risk.

JEL Classification: G21, G28

We thank Jaime Caruana, Douglas Gale, Charles Goodhart, Nobu Kiyotaki, Rosa Lastra, Julio

Segura, Claire Winton, and especially Javier Suarez for helpful comments. Talk about: CEMFI, Casado del Alisal 5, 28014 Madrid, Spain. E-mail: [email protected] com, [email protected]fi. es.

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Financial and regulating capital happen to be two conditions frequently used inside the analysis of the new structure for financial institution capital legislation proposed by Basel Committee on Bank Supervision (2004), known as Basel II. Specifically, many talks have featured the objective of delivering regulatory capital closer to economic capital. For instance , Gordy and Howells (2006, p. 396) state that " the primary objective under Expoliar 1 (of Basel II) is better position of regulatory capital requirements with ‘economic capital' required by investors and counterparties. ” To compare financial and regulatory capital we need to first make clear the meaning of every term. The definition of regulatory capital is clear: it is the minimum capital required by the regulator, which this newspaper we understand the capital expenses in the Interior Ratings-Based (IRB) approach of Basel II. Economic capital is usually defined as the main city level that's needed is to cover the bank's failures with a particular probability or confidence level, which is related to a preferred rating; observe, for example , Jones and Mingo (1998) or Carey (2001). However , it truly is our look at that this kind of desired solvency standard ought not to be taken as a primitive, yet should be based on an underlying goal function including the maximization of the market value of the bank. That is why, economic capital may be defined, and this is definitely the definition we will use hereafter, as the main city level that bank shareholders would choose in lack of capital regulation. 1

The primary purpose of this paper is always to analyze the differences among economic and regulatory capital in the context of the sole risk element model that underlies the IRB capital requirements of Basel 2. To calculate economic capital we make use of a dynamic unit in which investors choose, at the beginning of each period, the level of capital in order to improve the value of the financial institution, taking into account the chance that the bank always be closed if the losses through the period surpass the initial standard of capital. This closure guideline may be justified by assuming that a lender run happens before the investors can increase new fairness to cover the losses. Thus economic capital trades-off the expenses of funding the bank with costly value against one particular

As known by Allen (2006, g. 45), " the two concepts reflect the needs of different major stakeholders. For economic capital, the primary stakeholders are the bank's shareholders, as well as the objective is definitely the maximization of (their) riches. For regulatory capital, the principal stakeholders would be the bank's (depositors), and the goal is to reduce the possibility of loss. ”


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