economic and regulatory capital

Economic and Regulatory Capital in
Banking: What is the Difference?∗
Abel Elizalde

Rafael Repullo

CEMFI and UPNA

CEMFI and CEPR

July 2006

Abstract
We analyze the determinants of regulatory capital (the minimum required by regulation), economic capital (that chosen by shareholders without regulation), and actual capital (that chosen with regulation) in the single risk factor model of Basel II. We show that variables that only affect economic capital, such as the intermediation margin and the cost of capital, can account for large deviations from regulatory capital. Actual capital is closer to regulatory capital, but the threat of closing undercapitalized banks generates significant capital buffers. Market discipline, proxied by the coverage of deposit insurance, increases economic and actual capital, although the effects are small.
Keywords: Basel II, bank regulation, capital requirements, market discipline, deposit insurance, prompt corrective action, credit risk.
JEL Classification: G21, G28

∗

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

Segura, Andrew Winton, and especially Javier Suarez for helpful comments. Address: CEMFI,
Casado del Alisal 5, 28014 Madrid, Spain. E-mail: [e-mail], repullo@cemfi.es.

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Introduction

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, Gordy and Howells (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 economic and regulatory capital we must first clarify the meaning of each term.

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