Discussion Paper Details

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Title: Economic and Regulatory Capital: What is the Difference?

Author(s): Abel Elizalde and Rafael Repullo

Publication Date: December 2004

Keyword(s): bank regulation, Basel II, capital requirements, credit risk and market discipline

Programme Area(s): Financial Economics

Abstract: This Paper analyses the determinants of regulatory capital (the minimum required by regulation) and economic capital (the capital that shareholders would choose in absence of regulation) in the context of the single risk factor model that underlies the New Basel Capital Accord (Basel II). The results show that economic and regulatory capital do not depend on the same set of variables and do not react in the same way to changes in their common determinants. For plausible parameter values, they are both increasing in the loans? probability of default and loss given default, but variables that affect economic but not regulatory capital, such as the intermediation margin and the cost of capital, can move them significantly apart. The results also show that market discipline, proxied by the coverage of deposit insurance, increases economic capital, although the effect is generally small.

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Bibliographic Reference

Elizalde, A and Repullo, R. 2004. 'Economic and Regulatory Capital: What is the Difference?'. London, Centre for Economic Policy Research.