Economic and regulatory capital are two terms frequently used in the analysis of the new framework for bank capital regulation proposed by the Basel Committee on Banking Supervision (2004), known as Basel II. In particular, many discussions have highlighted the objective of bringing regulatory capital closer to economic capital. For example, Gordyand How ells (2006, p. 396) state that "the primary objective under Pillar 1 (of Basel II) is better alignment of regulatory capital requirements with economic capital demanded by investors and counterparties."
To compare economicandregulatorycapitalwemust first clarify the meaning of each term. The definition of regulatory capital is clear: it is the minimum capital required by the regulator, which in this paper we identify with the capital charges in theInternal Ratings-Based (IRB) approach of Basel II. Economic capital is usually defined as the capital level that is required to cover the bank's losses with a certain probability or confidence level, which is related to a desired rating; see, for example, Jones and Mingo (1998) or Carey (2001). However, it is our view that such desired solvency standard should not betaken as a primitive, but should be derived from an underlying objective function such as the maximization of the market value of the bank. For this reason, economic capital maybe defined, and this is the definition that we will use hereafter, as the capital level that bank shareholders would choose in absence of capital regulation.
The main purpose of this paper is to analyze the differences between economic and regulatory capital in the context of the single risk factor model that underlies the IRB capital requirements of Basel II. To compute economic capital we usea dynamic model in which shareholders choose, at the beginning of each period, the level of capital in order to maximize the value of the bank, taking into account the possibility that the bank be closed if the losses during the period exceed the initial level of capital.
This closure rule maybe justified by assuming that a bank run takes place before the shareholders can raise new equity to cover the losses. Thus economic capital trades-off the costs of funding the bank with costly equity against the benefits of reducing the probability of losing its franchise value, which appears as a key endogenous variable in the bank's maximization problem.
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Economic and Regulatory Capital in Banking: What is the Difference?
