How Economic Capital Relates to Regulatory Capital in Banking

Summary

The note asks whether a bank's internally estimated economic capital can satisfy a regulatory capital requirement, or whether the amounts must be added together. It presents two perspectives: one says the answer depends on jurisdiction and regulatory rules, and that supervisors may not recognize a bank's economic capital; another distinguishes economic capital for potential losses under normal conditions from regulatory capital aimed at stressed conditions. These differing descriptions show why the terms cannot be treated as interchangeable without checking the applicable framework.

The response mentions that some Basel advanced approaches allow internal capital estimates to substitute for regulatory calculations, while minimum ratios and buffers may still apply. It also gives an illustrative relationship between Tier 1 capital, a minimum requirement, and an economic-capital component. The discussion is not a universal rule: treatment varies by country, institution, and regulatory approach, and the brief answers do not fully reconcile their assumptions. A bank must consult the requirements that apply to it before concluding whether capital amounts overlap or stack.

Key ideas

• Economic capital is an institution's internal measure, while regulatory capital is determined under supervisory rules.
• The document gives differing views on whether economic capital may count toward regulatory requirements.
• Some Basel approaches may permit internal estimates within regulatory calculations, subject to floors and buffers.
• The purpose and level of each capital measure depend on the framework and jurisdiction.
• The examples do not establish a universal rule for adding or substituting capital amounts.

Tags

# Can Economic Capital cover Regulatory Capital?


# Can Economic Capital cover Regulatory Capital?












If economic capital is set by the institution to cover unexpected loss (given a confidence level) and regulatory capital is set by the regulator, can one "absorb" the other?

For example, if I determine I want my fictional bank to hold 5bn in economic capital as that corresponds to 99.98% confidence of my loss distribution and the local regulator says I need to hold a total of 3bn in regulatory capital based on my regulatory filings, can I say I'm holding 5 already for EC so I'm covered? Or do I have to hold 5 + 3?

## Answer by user9403 (score 1, accepted)

https://quant.stackexchange.com/a/21126

Depending on the bank and the country the bank operates in, regulators don't care about your bank's EC so you wouldn't have to hold 5+3; just 3 (or, if you are prudent/conservative, 5). In the US the regulatory capital requirements tend to be fairly conservative and I would think most banks have EC that is well below regulatory capital.

Under the Basel advanced approaches banks can substitute internal estimates of capital for regulatory capital, though I believe that the equity ratio has a hard floor of 5% and that frequently a 2% "buffer" is required above this.

## Answer by Egodym (score 2)

https://quant.stackexchange.com/a/21125

Economic Capital (EC) covers potential losses under normal conditions, whereas Regulatory Capital (RC) covers potential losses under stressed conditions. Thus, is not uncommon for the RC to be grater than the EC.

If $T1$ is the bank's Tier 1 capital and $T1^*$ is the related minimum capital, we have

$T1 = T1^* + EC$.

I suggest reading Chapter 22 of Resti & Sironi - Risk management and shareholder's value in banking.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.