Regulatory capital and economic capital

The connection between the concepts of regulatory capital and economic capital appears at first glance to be relatively obvious. Prudential standards, from which the notion of regulatory capital directly stems, are intended to ensure the soundness and stability of individual financial institutions and of the financial system as a whole. Thus the capital ratio links the concerns of regulators to those of bank directors and stockholders, resulting in a partial convergence in the methods for calculating regulatory and economic capital, and also, to some extent, in the objectives underlying those calculations. Over the past two decades, the convergence in the methodologies underlying these two concepts has been reinforced by the establishment of increasingly sophisticated prudential mechanisms – from the Cooke ratio in 1988 to the recent innovations introduced by the Basel II Accord – and by the parallel development of more efficient tools for measuring and analyzing banking risks. Thus the new Basel Accord, in providing a measure of regulatory capital that better reflects the risks inherent in each type of portfolio, resembles in many respects the methods that banks use to measure economic capital. In a banking environment that is both more risky and more competitive, efforts on the part of banks and supervisors to improve the solvency of the banking system must take into account the capacity of banks to earn profits while limiting excessive risk-taking. In the pursuit of profits, banks have a clear interest in reducing their credit risk, since this will tend to increase their margins, all other things being equal. This reduction in credit risk improves the efficiency of banks, and at the same time helps guarantee the financial health of individual institutions and the stability of the financial system as a whole. Despite these links, regulatory capital and economic capital do not necessarily coincide, because they serve fundamentally different objectives. The ultimate objectives of supervisors are to protect depositors, ensure the soundness of fi nancial institutions, and prevent financial crises. The objective of bank directors is to maximize the return to their shareholders, by maximizing the profits generated by the bank’s activities through the optimal allocation of capital across different business lines. Thus economic capital is concerned with the internal management of the institution, while regulatory capital is about ensuring the solvency of the institution and of the financial sector as a whole. While the tendency for regulatory capital and economic capital to converge is generally viewed as beneficial, a perfect alignment of the two concepts would not be desirable, for several reasons. To begin with, internal systems for measuring risks still have serious limitations, and the methods for measuring different types of risk are still very fragmented. Furthermore, the objectives of large financial conglomerates are not always consistent with the goal of financial stability. Finally, an alignment of internal practices could result in a higher degree of correlation of risk exposures across institutions, increasing systemic risk in the banking system.