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Economic and Regulatory Capital in Banking: What is the Difference?

by Abel Elizalde of CEMFI & UPNA, and
Rafael Repullo of CEMFI & CEPR

July 2006

Abstract: We analyze the determinants of regulatory capital (the minimum required by regulation), economic capital (that chosen by shareholders without regulation), and actual capital (that chosen with regulation) in the single risk factor model of Basel II. We show that variables that only affect economic capital, such as the intermediation margin and the cost of capital, can account for large deviations from regulatory capital. Actual capital is closer to regulatory capital, but the threat of closing undercapitalized banks generates significant capital buffers. Market discipline, proxied by the coverage of deposit insurance, increases economic and actual capital, although the effects are small.

JEL Classification: G21, G28.

Keywords: Basel II, bank regulation, capital requirements, market discipline, deposit insurance, prompt corrective action, credit risk.

Published in: International Journal of Central Banking, Vol. 3, No. 3 (September 2007), pp. 87-117.

Previously titled: Economic and Regulatory Capital What is the Difference?

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