Bank capital: a myth resolved

In order to promote financial stability, regulatory authorities pay a lot of attention in setting minimum capital levels. In addition to these requirements, financial institutions calculate their own economic capital reflecting the unexpected losses and true risk according to the specific characteristics of their portfolio. The current Basel I framework pays little or no attention to the creditworthiness of a borrower in deciding on the regulatory capital requirements. As a result, a lot of banks remove low-risk assets from their balance sheets and only retain relatively high risk assets on balance. The recently introduced Basel II framework should result in a further convergence between regulatory and economic capital. However, recent papers (Elizalde et al., 2006; Jackson et al., 2002 and Jacobson et al. 2006) argue that also under Basel II, regulatory and economic capital will have different determinants. This paper first gives an overview of capital adequacy and then further describes the differences and similarities between economic and regulatory capital based on a literature review.