DP4770 Economic and Regulatory Capital: What is the Difference?

Author(s): Abel Elizalde, Rafael Repullo
Publication Date: December 2004
Keyword(s): bank regulation, Basel II, capital requirements, credit risk, market discipline
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4770

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.