Operational Risk Management

CHAPTER 8Regulatory Capital and Modeling

REGULATORY CAPITAL: RATIONALE AND HISTORY IN A NUTSHELL

Financial companies, like households and every economic agent, have two sources of funding: capital, also referred to as own funds, and debt. Bank debts are essentially made of retail deposits – the current and savings accounts familiar to most people. As with every economic agent, revenues generated on the asset side repay debts. If the activity slows down, revenues dry up, or if losses incurred are too large, assets are not enough to repay the debts. In the case of a bank, it is unable to repay people's deposits. Banks need own funds, or capital, to make sure that they can absorb whatever losses they may face without defaulting on their debt obligations on the liability side and disrupting the loan market and the financial market on the asset side, with terrible systemic consequences for the economy.

Since the Great Depression, which led to an estimated 15% drop in the US gross domestic product (GDP) between 1929 and 1932, government and public regulatory authorities have developed rules and regulations to restrict and monitor the activities of banks. The most important measure was the Glass‐Steagall Act, separating commercial and investment banking. In particular, banks were forbidden to simultaneously lend and hold shares in the same company, in order to avoid conflict of interest and over‐lending. In 1974, following serious disturbances in the banking market, notably the failure ...