2.11 Economic vs. regulatory capital
Portfolio managers try to optimize the use of economic and not
regulatory capital. What is the difference? First, we emphasize what
they share; they both represent capital which the bank must hold
to serve as a cushion against unexpected losses. Regulatory capital,
however, is determined by the Basel accord according to a number
of forfeits dependent upon outstanding balances and the category
of counterparty. This deﬁnition produces an incorrect measure in
the context of marked to market accounting; hence the need for
These shortcomings can be categorized as the adoption of a measure
for credit risk which does not distinguish between corporates. Further
governments are assigned a very low credit risk somewhat arbitrarily.
Finally the forfeits are identical for short- and long-term commitments,
when obviously the latter carry higher risk. Most alarmingly the regu-
lators measure portfolio risk as the simple addition of the individual
risks which ignores diversiﬁcation effects. This has the unfortunate
effect of a diversiﬁed portfolio and a concentrated portfolio potentially
having the same risk.
These concerns are being addressed within the new framework of
Basel. We cover this in Section 2.16.
Due to these inefﬁciencies in measuring credit exposure any target
performance based upon regulatory capital may not depend upon the
true credit risk. Economic capital is intended to correct these distortions.
Ultimately any difference will be reﬂected in customer pricing; get
this wrong and the bank could end up subsidizing the competition.
Figure 2.9 shows how the use of regulatory capital will miss-price
The amount of economic capital is derived using the VAR method-
ology. There are a number of distinct steps involved in the derivation.
The shape of the loss distribution.
A tolerance level.
A horizon period.
It will be helpful to inspect the loss distribution of a loan portfolio
depicted in Figure 2.10. The reader should note the distinct shape in
comparison to a normal distribution. This is often interpreted as the
distinction between credit and market risk. This can be misleading as
market risk itself is really only approximated by the normal distribu-
tion. (The reason the normal distribution is so important in ﬁnance is
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