Introduction

In the world of banking and financial risk management, understanding the concepts of economic capital and regulatory capital is essential. These two forms of capital play distinct roles in safeguarding a bank’s stability, profitability, and ability to absorb unexpected losses. In this chapter, we will explore the differences between economic capital and regulatory capital and their significance in the context of risk management.

Economic Capital

Economic capital is the amount of capital that a bank needs to hold to cover potential losses arising from various risks it faces. It is an internal measure used by banks to assess and allocate capital based on their specific risk appetite and business activities. Economic capital is not mandated by external regulators and is tailored to the bank’s unique risk profile. It provides a more realistic view of the risks a bank is exposed to, beyond the minimum capital requirements set by regulatory authorities.

Example: A bank conducts a comprehensive risk assessment and determines that it needs to hold $100 million in economic capital to cover potential credit, market, and operational risks based on its portfolio and activities.

Regulatory Capital

Regulatory capital, on the other hand, is the minimum amount of capital that banks are required to maintain by regulatory bodies such as the Basel Committee. It serves as a safety net to protect depositors and the financial system. Regulatory capital consists of three tiers:

a) Tier 1 Capital: Comprises Common Equity Tier 1 (CET1) capital, including common shares and retained earnings. It is the highest-quality capital that acts as a buffer against losses.

b) Tier 2 Capital: Includes instruments like subordinated debt and hybrid capital, providing additional loss-absorbing capacity.

c) Tier 3 Capital: Intended to cover short-term market risk in trading books, but is no longer used under Basel III.

Example: Under Basel III regulations, banks must maintain a minimum Common Equity Tier 1 (CET1) capital ratio of 4.5%, Tier 1 capital ratio of 6%, and Total Capital Ratio of 8%.

Differences Between Economic Capital and Regulatory Capital

Economic capital and regulatory capital differ in several key aspects:

a) Purpose: Economic capital is used for internal risk management and decision-making, while regulatory capital is mandated by external regulators to ensure financial stability.

b) Flexibility: Economic capital is flexible and can be adjusted to reflect a bank’s specific risk profile, while regulatory capital follows standardized rules set by regulators.

c) Risk Coverage: Economic capital covers all risks faced by the bank, including operational, market, and business risks, while regulatory capital primarily focuses on credit risk and market risk.

d) Buffer Capacity: Economic capital is designed to provide a cushion against unexpected losses, while regulatory capital sets minimum capital requirements to protect depositors and the financial system.

Case Studies

Case Study 1: Regulatory Capital Requirements

During the 2008 global financial crisis, several banks faced severe stress on their capital due to the collapse of the subprime mortgage market. Many banks were forced to raise additional capital to meet the regulatory requirements and maintain stability. This crisis highlighted the importance of maintaining adequate regulatory capital levels to weather economic downturns.

Case Study 2: Economic Capital Requirements

ABC Bank, a global financial institution, decides to implement an economic capital framework to improve its risk management practices. The bank performs a thorough assessment of its loan portfolio, investment positions, and operational exposures. Based on this analysis, ABC Bank determines that it needs to allocate an economic capital of $500 million to ensure its resilience to potential risks.