Regulatory Capital & Economic Capital

[liewpw05]

Hi David,

I need some help in understanding :regulatory capital & economic capital and how they come together in the FRM course.I have some introduction into economic capital while reading counterparty risks and would like to get a bigger picture of what's going on.Here is what i have come to know from the various readings:

Both regulatory and economic capital is based on the concept of unexpected loss at a certain high confidence level.The difference between the two is economic capital is the internal measure used by companies to allocate capital and make strategic decisions. Also,economic capital tend to be lesser than regulatory capital if both were measured on the same market consistent basis due to the fact that economic capital tend to allow for correlations between market, credit and operational risks while regulatory capital tend not to.

Would appreciate if you add some more and give some comments.

Thanks,

Regards,
Peggy

 

[David Harper CFA FRM]

Peggy,

Yet another insightful observation. This was an AIM last year but was inexplicably dropped in the 2008.

First just a minor caveat: some authors will imply that economic capital refers to capital that covers credit risk. That's fine, but the FRM assigned readings tend NOT to mean that. In the FRM, economic capital refers to capital comprehensively. Capital that covers market + credit + operational risk. That said...

These terms have more in common than they do have differences. Both refer to the capital held (which is equity or equity-like capital. In the bank balance sheet, Basel II formalizes rules around equity-like capital, but at the end of the day: assets - liabilities = equity. The equity (plus the equity-like such as short-term subord debt) is the "cushion" against insolvency.

Both regulatory and economic capital refer to the cushion against insolvency: how much capital is needed for unexpected losses? The difference is "merely:" who is the constituent? Regulatory capital in the FRM refers to Basel. As you suggest, regulatory capital is externally mandated. Economic capital, as you suggest, is internal. The way i would prefer to say it is that EC is based on either (i) the stakeholders collectively, which includes regulators or (ii) the shareholders, which indirectly and arguably, give consideration to all stakeholders.

In regard to their commonality, perhaps you will like this blog post from January: http://www.bionicturtle.com/learn/article/capital_at_risk_versus_economic_capital/

The point is that both Basel II (regulatory capital) and economic capital cover losses up to unexpected losses. And this is essentially a VaR concept. The only difference from market VaR is that credit VaR is net of the expected losses. On way to view Basel II, at least at the advanced levels, is that it is a rule for economic capital: across the three big risk buckets, it is mandating economic capital. This is the same reason that EC is popular internally, it is a common yardstick across different risk types. But you make a great observation about correlations: Basel II does not give an credit for credit/market/operational risk correlations. But on the other hand, practitioner approaches to internal economic capital almost certainly do.

While the reg capital is externally mandated, the economic capital (because it is equity and equity-like) is the key shareholder measure: it is the denominator in RAROC.

Finally, I am copying here an extract from the AIM on this last year:

Economic capital absorbs unexpected losses, up to a certain point, depending on the desired confidence level. The confidence level is a policy decision that should be set by senior management and endorsed by the board. Economic capital is most relevant to shareholders. First set aside reserves for expected losses; e.g., such losses are priced into higher yields. Economic capital does not cover expected losses; economic capital is meant to absorb unexpected losses.

Regulatory capital is rule-based (e.g., BIS 88, BIS 98) with the intention to ensure enough capital is in the banking system. Most financial institutions hold more capital than required by regulators.

David