Aug 21

Regulatory versus Economic Capital (Paper)

by David Harper, CFA, FRM, CIPM

FRM |

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Phong T.H. Ngo recently published Capital-Risk Decisions and Profitability in Banking: Regulatory versus Economic Capital. He tries to explain an apparent paradox: why do banks, on average, hold more capital than regulations require? That is, if higher leverage (less equity) implies greater profitability (ROE), why don’t banks hold exactly the minimum regulatory capital?

His mathematically-implied answer implicates a potential unintended consequence of regulations like Basel II: “it appears that regulatory pressure whether one views it as ex-ante monitoring or an ex-post cost in the event of breach enters banks objective function through the additional constraint on capital and either refocuses banks’ attention from and/or limits their ability in selecting an optimal level of economic capital to selecting an optimal level of regulatory capital.” In other words, just like the “costs of financial distress” prevent a company from increasing leverage (debt:equity) beyond a certain point, so to does the cost/threat of regulatory breach keep regulatory capital above the minimum.

For FRM candidates, his study operationalizes useful definitions:

  • Regulatory capital. Capital adequacy ratio (CAR): in accordance with the Basel Accord, CAR is the ratio of total capital (Tier 1 capital plus Tier 2 capital) to total risk-weighted assets (RWA). “There is no reason to expect that the CAR is the same ratio that banks monitor in managing their economic affairs….”
  • Economic capital: Owner’s Equity divided by Total Assets (OE/TA)

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