Economic and Regulatory Capital: What is the Difference?

25 Pages Posted: 15 Feb 2005

See all articles by Abel Elizalde

Abel Elizalde

Centre for Monetary and Financial Studies (CEMFI)

Rafael Repullo

Centre for Monetary and Financial Studies (CEMFI); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Date Written: December 2004

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.

Keywords: Bank regulation, capital requirements, market discipline, credit risk, Basel II

JEL Classification: G21, G28

Suggested Citation

Elizalde, Abel and Repullo, Rafael, Economic and Regulatory Capital: What is the Difference? (December 2004). CEPR Discussion Paper No. 4770. Available at SSRN: https://ssrn.com/abstract=666823

Abel Elizalde

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
Spain
+34 91 429 0551 (Phone)
+34 91 429 1056 (Fax)

HOME PAGE: http://www.cemfi.es/~elizalde/

Rafael Repullo (Contact Author)

Centre for Monetary and Financial Studies (CEMFI) ( email )

Casado del Alisal 5
28014 Madrid
Spain
+34 91429 0551 (Phone)
+34 91429 1056 (Fax)

HOME PAGE: http://www.cemfi.es/~repullo/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://www.ecgi.org

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