Academics, practitioners, and regulators all recognise and agree that capital is required for banks to operate smoothly because capital provides protection. The critical question is how much, and what type of, capital a bank needs to hold so that it has adequate protection.
In the simplest form, capital represents the portion of the bank's liabilities which does not have to be repaid and therefore is available as a buffer in case the value of the bank's assets decline. If banks always made profits, there would be no need for capital. Unfortunately, such an ideal world does not exist, so capital is necessary to act as a cushion when banks are impacted by large losses. In the event that the bank's asset value is lower than its total liabilities, the bank becomes insolvent and equity holders are likely to choose to default on the bank's obligations.
Naturally, regulators would hold the view that banks should hold more capital, so as to ensure that insolvency risk and the consequent system disruptions are minimised. On the other hand, banks would wish to hold the minimum level of capital that supplies adequate protection, since capital is an expensive form of funding, and it also dilutes earnings.
There are 3 views on what a bank's minimum capital requirement should be.
Regulatory view
Regulatory capital is the minimum capital requirement as demanded by the regulators; it is the amount a bank must hold in order to operate. A regulator's primary concern is that there is sufficient capital to buffer a bank against large losses so that deposits are not at risk, with the possibility of further disruption in the financial system being minimized. Regulatory capital could be seen as the minimum capital requirement in a “liquidation / runoff” view, whereby, if a bank has to be liquidated, whether all liabilities can be paid off.
Regulatory capital is a standardised calculation for all banks, although, there would be differences to various regulatory regimes. The process by which it is calculated is also transparent, this allows meaningful comparisons between banks under Pillar 3 disclosures.
Economic view
Economic capital is the theoretical view on minimum capital requirement based on the underlying risks of the bank's assets and operations. Economic capital could be seen as the minimum capital requirement in a “going concern” view, whereby, a bank is in continual operation, and it is only concerned with holding enough capital to ensure its survival.
Economic capital was originally developed by banks as a tool for capital allocation and performance assessment. For these purposes, it did not need to measure risk in an absolute, but only in the relative sense.
Over time, with advances in risk quantification methodologies and the supporting technological infrastructure, the use of economic capital has extended to applications that require accuracy in the measurement of risk. This is evident in the ICAAP, whereby banks are required to quantify the absolute level of internal capital.
Although, economic capital has evolved sufficiently to be used alongside regulatory initiatives, it should remain a hypothetical measurement, and be used primarily as a basis for risk adjusted performance measurement (RAPM/SVA) and risk-based pricing (RAROC). This is because if economic capital is used to set minimum capital requirement, banks will have a conflict of interest in producing low estimates to minimise its capital holding. And since economic capital modelling is an internal measurement, there is no standardisation across the banking industry, which in turn, makes regulation difficult.
Rating agency view
Rating agency capital is the minimum capital a bank needs to hold in order to meet a certain credit rating. The amount of capital and the type of capital (Tier 1 & 2) a bank holds in relation to its total risk weighted assets is a crucial input to the mechanism in which rating agencies use to assess a bank's capital adequacy and its subsequent credit rating. And since credit ratings provide important signals to the market on a bank's financial strength, they can have significant downstream impact on a bank's ability to raise funds, and also the cost at which the funds are raised. Therefore, having sufficient capital to meet rating agency requirement becomes an important consideration for senior management.
Rating agency capital differs to regulatory and economic capital in that it seeks to neutralize the impacts of different regulatory regimes, Basel II options, and individual banks’ risk assessments. That is, it aims to provide a globally comparable capital measure.
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